CHAPTER TWO

2. THE ACCOUNTING CYCLE (INFORMATION SYSTEM DEP’T)

2.1. NATURE OF AN ACCOUNT

In order to provide the necessary information to users, accountants maintain separate records on
each element of the financial statements.
The record includes beginning cash balance, cash payments & cash collections during the
period. This record is called an account.
Definition: An account is a subdivision under the three elements of the accounting equation
used to record the changes over a single element in the financial statements. An account has
three parts, Title, Debit, and credit. For illustration purposes an account can be represented in
the form of capital letter ‘T’.

Example
Title
Debit Credit
Dr Cr
2.2 CLASSIFICATION+S OF ACCOUNTS

Accounts are classified into five: assets, liabilities, capital, revenue and, expenses. The first
three are called balance sheet accounts and the other two are called income Statement account
The five groups of account are discussed below.
1. Assets: Resources owned by a business or individual are called assets. Assets could be
tangible or intangible. Tangible assets are assets having physical existence, like cash, land,
computer, stationery materials. Intangible assets do not have physical existence. Example:
Goodwill, Copyright, patent right.
On the balance sheet assets are classified into two current assets and non – current assets.
Current Assets – are those assets, which can be used, sold, or converted into cash within one
accounting year. Example: cash, supplies, prepayments, receivables etc.
Non-current Asset: All assets other than current assets are called non-current assets. Example:
land, patent right, office equipment, vehicles.

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2. Liabilities: Creditors’ claims to the assets of a business; amounts owed to creditors are called
liabilities. Like assets, liabilities are classified in to two as current liabilities and non – current
liabilities
Current liabilities: The liabilities that are payable within (one) accounting year are known as
current liability. Example: Accounts Payable, Rent Payable, Salary Payable.
Non – Current Liabilities: Debts that are not required to be paid within one accounting period.
Example long term notes payable.
3. Capital: The excess of the assets of a business over its liabilities is referred to as capital. It is
the equity of the owner in the business.
4. Revenue: Are increases in owner’s equity resulting from the main operations of the business.
Examples of revenue accounts are sales, interest income, tuition fee, and sales commission.
5. Expenses: are decreases in owner’s equity in the process of earning revenue. For example, a
hotel has to pay salary to its workers for the services rendered to clients in order to get the
income form customers (revenue) the Hotel has pay salary to the employees (expense).
Example of expenses: Salary, insurance, depreciation, supplies, utilities, rent etc.
2.3 CHART OF ACCOUNTS
The number and name of accounts used by an organization depends on the nature of its
operation. The list of accounts used by an organization and their codes is called the chart of
accounts. Look at the following chart of accounts of Bati Transport
Bati Transport
Chart of Accounts

Asset Account number

Cash--------------------------------------------------------------------------11
Accounts Receivable------------------------------------------------------ 12
Supplies----------------------------------------------------------------------13
Prepaid Insurance-----------------------------------------------------------14
Equipment------------------------------------------------------------------- 15
Accumulated Depreciation –Equipment---------------------------------16
Truck--------------------------------------------------------------------------17
Accumulated depreciation – Truck----------------------------------------18

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Liabilities
Accounts Payable-------------------------------------------------------------21
Notes Payable-----------------------------------------------------------------22
Owners’ Equity
Yimer Adem, Capital----------------------------------------------------------31
Yimer Adem Drawing-------------------------------------------------------32
Income Summary-------------------------------------------------------------33
Revenue
Service income----------------------------------------------------------------41
Expense
Salaries Expense --------------------------------------------------------------51
Rent Expense ------------------------------------------------------------------52
Utilities Expense---------------------------------------------------------------53
Supplies Expense--------------------------------------------------------------54
Insurance Expense-------------------------------------------------------------55
Maintenance Expense---------------------------------------------------------56
Depreciation Expense---------------------------------------------------------57
Truck Expense-----------------------------------------------------------------58
Miscellaneous expense--------------------------------------------------------59

In the chart of accounts, the asset accounts are listed according to their liquidity. Liquidity is the
ease with which an asset can be converted in to cash. Cash is the most liquid asset so it is listed
first. Accounts other than cash will be listed in their frequency of use or in alphabetical order
The account number is a code to identify accounts. The number could be a two digit, three digit
or more digits. In the above example a two – digits code is used.
When the chart of accounts is prepared in an organization we say the ledger is opened.

2.4 RULES OF DEBITS AND CREDITS

As shown above every account has three parts. These parts are discussed below:
Title – The name of the account. This is written at the top of the account.
Debit – is the left hand side of an account –Debit is abbreviated as ‘Dr.’ when an amount is
entered on the left side of an account we say the account is debited or charged.

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Credit – is the right hand side of an account. Credit is abbreviated as “Cr”. An account is said to
be credited when an amount is entered on the right hand side of the account
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 except expenses.
The above general rule will be expanded as follows

Debit Credit
-Increase in assets -Decrease in assets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in capita
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.
The normal balance of an Account
Normal balance refers to the side of an account (Dr. or Cr.), which will have greater entries than
the other. The increasing side will be the normal balance for account
Example: The normal balance of all asset accounts is debit.

2.5 JOURNALIZING BUSINESS TRANSACTIONS

When a business transaction takes place, source documents will be obtained and recorded. The
accounting record in which a transaction is initially recorded is known as a journal. The journal
is therefore referred to as “The book of original entry”.
The process of recording a business transaction in the accounting record is called journalizing.
The Journal commonly used to record all types of transactions is the General Journal. This
Journal includes the following parts, entered step by step.
1. The date of the transaction
2. The title of the account debited
3. The title of the account credited
4. The amount of debit and credit
5. Brief explanation of the entry or reference to the source document.

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Look at the following General Journal and notice where each of the above information is found.
Journal page
Date Description P.R Debit Credit
Year
Month da Debited account title XXX XX
y
Credited account title X XX XX
Explanation

There are also other types of Journals like, known as special journals that are used to record
specific types of transactions. The cash Journal, for instance, is used to record only transactions
affecting cash. The General Journal is used for illustrations in this chapter.

Steps in Journalizing a Transaction

The following steps should be followed in recording a transaction in the journal.

1. Record the date - Insert the year, the month, and the date as shown above.
2. Record the Debit- Insert the account debited in the description column and the amount of
debit in the debit column.
3. Record the credit- Insert the account credited below the debited account and indented to
the right in the description column and the amount of credit in the credit column.
4. Explanation- Write a brief explanation or reference to source document in the description
column, when necessary.

Each one set of debits and credits for a transaction is called a journal entry.

In recording a business transaction answer the following questions based on the transaction to be
recorded may help you.

a) Which accounts are affected?

b) Is each account increased or decreased?
c) Which account is debited and which is credited?
d) Prepare the complete journal entry.

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Example. On January 10, 2003 Brihan P.L.C paid Birr 6,000 to its employees as a salary for the
first week of the year.

This business transaction will be analyzed and recorded as follows.

a) Which accounts are affected? Answer: Cash and Salary Expense.
b) Is each account increased or decreased? Answer: cash is decreased and salary expense is
increased.
c) Which account is debited and which is credited? Answer: Salary Expense is debited
because increase in expenses is recorded on the debit side. And cash is credited because
decrease in assets is recorded on the credit side.
d) Prepare the complete Journal entry.

2003 Description
Jan. 1 Salary expense 6000 00
0
Cash 6000 00
Payment of salary

Note: A journal entry is the complete presentation of the record in the journal.
Check Your Progress Exercise - 2
Journalize the following transaction by answering 4 questions suggested above.
 On January 11, 2003 Brihan bought a building for Birr 150,000 on credit.
Illustration
To illustrate the complete accounting cycle, we will consider the following list of selected
transactions. The transactions were completed by Bati Transport in the month of January 2003.
January 1. Ato yimer took Birr 450,000 from his personal savings and deposited it in the name of
Bati transport.
January 2. Bati Transport purchased two used trucks for Birr 150,000 each, on cash.
January 4. Bati Transport received a check for Birr 650 for services given to Alem
Trading.
January 4. Received an invoice for truck expenses Birr 90.
January 11. Paid Birr 600 for Awash Insurance Company to buy an insurance policy for
its trucks.

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January 16. Ato Yimer issued a check for Birr 9,400 to the workers as a salary for
two weeks.
January 20. Bati trading Billed Muradu Supermarket for goods transported from
Djibouti to Gondar Birr 2,650
January 21. Ato Yimer wrote a check for birr 450 to have one of the trucks repainted
January 21. Bati trading purchased stationary materials and other supplies of Birr 740 on
account
January 22. Office equipment of Birr 11,600 is bought on account.
January 23. Purchased an additional truck for Birr 250,000 paying birr 100,000 in cash
and issuing a note for the difference.
January 23. Recorded services billed to customers on account birr 14,600.
January 25. Received cash from customers on account Birr 15,000.
January 27. The owner withdrew Birr 500 in cash for his personal use.
January 28. Paid Birr 9,400 to workers as a salary for the last two weeks of the month.
January 30. Paid telephone expense of Birr 95 and electric expenses of Birr 125 for the
month.
January 30. Paid other miscellaneous expenses Birr 50.
January 31. Paid Birr 4,000 as a rent for a building used for office space.
These transactions are journalized as follows:

Date Description Debit Credit

2003 Cash 450,000
Jan.1 Yimer Capital 450,000
To record investment by owner
2 Truck 300,000
Cash 300,000
Purchase of trucks
4 Cash 650
Service Income 650
Cash received from customers
4 Truck Expenses 90
Accounts Payable 90
Service received in advance
11 Prepaid Insurance 600
Cash 600
Purchase of insurance policy
16 Salary Expense 9,400

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 Cash 9,400
Payment of salary
20 Accounts Receivable 2,650
Service Income 2,650
Provision of service
21 Truck Expense 450
Cash 450
Cash paid to repaint truck
21 Supplies 740
Accounts Payable 740
Purchase of supplies of account
22 Office Equipment 11,600
Accounts Payable 11,600
Purchase of equipment
23 Truck 250,000
Cash 100,000
Notes Payable 150,000
Purchase of truck
23 Accounts Receivable 14,600
Service Income 14,600
Provision of service on account
25 Cash 15,000
Accounts Receivable 15,000
Collection of cash
27 Drawings 500
Cash 500
Owner withdrawals
28 Salary Expense 9,400
Cash 9,400
Payment of salary
30 Utilities Expense 220
Cash 220
Payment for telephone, electricity
30 Miscellaneous Expenses 50
Cash 50
Payment for various expenses
31 Rent Expense 4,000
Cash 4,000
Payment of Rent

2.6 POSTING FROM THE JOURNAL TO THE LEDGER

After the information about a business transaction has been journalized, that information is
transferred to the specific accounts affected by each transaction. This process of transferring the
information is called posting.

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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.

The two-column account:

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

The four-column account:

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

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

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Account Cash Account Number
Balance
Date Item P.R Debit Credit Debit Credit
2003 450,000 00 450,000 00
Jan 1
2 300,000 00 150,000 00
4 650 00 150,650 00
11 600 00 150050 00
16 9,400 00 140650 00
21 450 00 140200 00
23 100,000 00 40200 00
25 15,000 00 55200 00
27 500 00 54200 00
28 9,400 00 45300 00
30 220 00 45,080 00
30 50 00 45,030 00
31 4,000 00 41,030 00

Note. The item column is usually left blank. In some cases the word balance is written when the
account is carried forward to a new page.

2.7 THE TRIAL BALANCE

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

The trial balance for our illustration, Bati Transport is presented below. The amounts are taken
from the balances of the accounts after all the transactions have been posted. Therefore, after
posting the above transactions, you should get the final balances shown on the trial balance in the
end.

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 Bati Transport
Trial Balance
January 31, 2003

Cash 41,030 00
Accounts Receivable 2,250 00
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 11,600 00
Truck 550,000 00
Accounts payable 12,430 00
Notes payable 150,000 00
Yimer capital 450,000 00
Yimer drawing 500 00
Service income 17,900 00
Salary expense 18,800 00
Rent expense 4,000 00
Utilities expense 220 00
Maintenance expense 450 00
Truck expense 90 00
Miscellaneous expense 50 00
Total 630,330 00 630,330 00

2.7.1 Proof Provided by the 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.

1. Error in preparing the trial balance including

-Addition error
-The amount of an account balance was in correctly listed on the trial balance
- A debit balance was recorded as a credit or vice versa
- A balance was entirely omitted.

2. 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

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2.8 ADJUSTMENTS

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 are left in hand.

The adjusting entry prepared at the end of the year to adjust the supplies account will be
1990 Supplies expense 1,750
Dec31 Supplies 1,750

Note: 1. Adjustments are dated as the last day of the year.

2. The accounting year here – we assume, runs from January 1- December 31.
Additional examples on adjustments will be given below under the topic ‘worksheet’
2.8.1 The Accrual Basis and the Cash Basis of Accounting.

1. 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.

2. 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.

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2.8.2 The Matching Principle
We have discussed three concepts and principles in accounting in chapter one. Now we will see
one more principle, the matching principle. This principle states that the expense of a period
have to be matched with the revenue of that period regardless of when payment is made. In
order to do this, the accrual basis of accounting requires the use of an adjusting process at the
end of the period so that revenues and expenses of the period will be determined properly.
The accounts in the ledger of our illustration that require adjustment and the adjusting entry for
the accounts are presented below.

a) Supplies – The supplies account has a debit balance of Birr 740. The cost of supplies in hand
on July 31 is determined to be Birr 400. The following adjusting entry is required to bring the
balance of the account up to date:

Supplies expense…………………………….340
Supplies……………………………………..340

b) Prepaid insurance – Analysis of the policy showed that three – fourth of the policy is
expired. That is only Birr 150 of the policy is applicable to future periods. The adjusting entry
to transfer the expired part of the insurance to expense will be.

Insurance expense ……………………….450

Prepaid insurance………………………..450

c) Service Income – At the end of the month unbilled fees for services performed to clients
totaled Birr 6,500.

This amount refers to an income earned but to be collected in the future. The journal entry to
record it will be
Accounts receivable………………………….6, 500
Service income………………………………6,500

All the above adjusting entries will be inserted in the adjustment column of the worksheet in
front of the accounts affected.

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Note – The letters a, b & c are used to cross-reference the debits and credits to help future review
of the worksheet.

2.9 WORKSHEET FOR FINANCIAL STATEMENTS

Most of the data required to prepare the accounting reports (financial statements) is 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.

The worksheet for Bati Transport is given below. The five parts of the body are discussed as
follows. You are advised to read and understand the discussions before you look at the respective
columns of the worksheet.

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 Bati Transport
Work Sheet
For the month ended jan.31, 2003

Account Title Trial Balance Adjustment Adjusted Trial Income Balance sheeet
balance statement
1 Cash 41,030 41,030 41,030
©
2 Accounts receivable 2,250 6,500 8,750 8,750
(a)
3 Supplies 740 340 400 400
(b)
4 Prepaid Insurance 600 450 150 150
5 Office equipment 11,600 11,600 11,600
6 Truck 550,000 550,000 550,000
7 Accounts payable 12,430 12,430 12,430
8 Notes payable 150,000 150,000 150,000
9 Yimer Capital 450,000 450,000 450,000
10 Yimer drawing 500 500 500
©
11 Service revenue 17,900 6,500 24,400 24,400
12 Salary expense 18,800 18,800 18,800
13 Rent expense 4,000 4,000 4,000
14 Utilities expense 220 220 220
16 Truck expense 540 540 540
17 Miscellaneous 50 50 50
Expense
18 630,330 630,330
(a)
19 Supplies expense 340 340 340
(b)
20 Insurance expense 450 450 450
21 7290 7290 636,830 636,830
22 Net income
23 24,400 24,400 612,430 612,430
1. The trial balance column – this is the same trial balance we have prepared before. The trial
balance column of the work sheet can be brought direct from the ledger or from a separate trial
balance.

2. The Adjustment column – As mentioned previously, some account balances have to be

adjusted at the end of the year.

3. The Adjusted Trial Balance Column – The accounts that require adjustment are now
adjusted. Transferring the trial balance column amounts combined with the adjustment column
amounts will complete the adjusted trial balance column of the worksheet.

4. The income statement and the balance sheet columns – Transfer the income statement
account balances (revenue &expenses) to the income statement and balance sheet account

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balances (Asset, Liability &owners equity) to the balance sheet columns. Note that what we
have to transfer is the adjusted trial balance column amounts, to the corresponding columns.

Look at the 22nd row. It shows the net income for the month and it is added to the two columns
(Income statement Dr. and balance sheet cr.) as a balancing figure.

2.10 FINANCIAL STATEMENT PREPARATION

After the work sheet is completed financial statements could be prepared easily. In chapter one
we have discussed four basic financial statements prepared by most organizations. Here, we will
prepare three of these statements for Bati Transport form the worksheet.

1. Income statement. All the data required to prepare the income statement is brought from the
worksheet.

Bati Transport
Income statement
For the month ended. Jan 31, 2003

Service Income …………………………………………………………Birr 24,400

Operating expenses
Salary expense………………………..Birr 18,800
Rent “…………………………………….4, 000
Insurance “……………………………450
Supplies “…………………………….340
Utilities “……………………………..220
Truck “……………………………..540
Miscellaneous “………………………………50
Total operating expense………………………………………24,400
Net Income…………………………………………………Birr 0
2. Statement of owner’s equity – This statement shows the beginning balance of capital and the
changes that affected it.

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The balance of the owners equity account (Yimer capital) 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 priod or not. In our illustration there is no additional investment.

Bati Transport
Statement of Owner’s equity
For the month ended January 31, 2003

Yimer capital January 1, 2003………………………………Birr 450,000

Net income for the month………………….birr 0
Less: Withdrawal…………………………………... (500) (500)
Yimer capital, January 31, 2003……………….…………….Birr 449,500

3. Balance sheet – The data to prepare this statement will be taken from the worksheet and the
other financial statements. Note that assets and liabilities are classified as current and non –
current.
Bati Transport
Balance sheet
January 31, 2003

Assets
Current Assets:

Cash…………………………………………Birr 41, 030

Accounts Receivable…………………………….. 8,750
Supplies…………………………………………… 400
Prepaid insurance…………………………………….150
Total current assets……………………………………………Birr 50,330

Plant Asset (None-Current Assets):

Office equipment……………………………..Birr 11,600

Truck………………………………………………550,000 561,600
Total asset………………………………………………………Birr 611,930

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Liabilities
Current liabilities
Accounts payable……………………………..Birr 12,430

Non-current liabilities
Notes payable……………………………………..150,000

Total liabilities……………………………………………………Birr 162,430

Owner’s equity

Ato Yimer Capital…………………………………………………………….. 449,500

Total liability and owners equity………………………………………….Birr 611,930

2.11 THE CLOSING PROCESS

Some of the accounts in the ledger are temporary accounts used to classify and summarize the
transactions affecting capital (owners equity). These accounts will be closed after financial
statements are prepared. That is, their balances will be transferred to the Capital account. The
temporary accounts that have to be closed are revenue, expense and withdrawal accounts.

Steps in closing:

1. Closing revenue accounts - Debit each revenue account by its balance and credit the
‘Income Summary’ account by the 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 capital account depends on the nature of operation; credit if result is
profit and debit if result is loss.

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

The temporary accounts of Bati transport are closed as follows.

2003 service revenue………………….24, 400

January Income summary…………………………………25,300
31 Closing revenue
Income summary-------------------------------------------24, 400
31 Salary expense………………………..18,800
Rent expense……………………………4,000
Maintenance expense………………….. 450
Insurance expense………………………..450
Supplies expense…………………………340
Utilities expense………………………….220
Truck expense …………………………… 90
Miscellaneous expense…………………….50
(Closing expenses)
2003 Income summary………………0
January 31 Yemer Capital………………………..0
(Closing income summary) since profit is zero, it is not necessary to record it.
31 Yimer capital…………………...500
Yimer drawing………………………..500
(Closing withdrawal)

The above closing entries have transferred the balance of the temporary accounts to the
permanent capital account.

2.12 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

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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.

Bati Transport
Post – Closing trial balance
Jan 31, 2003

Cash……………………………………………Birr 41,030
Accounts Receivable ………………………………...8,750
Supplies…………………………………………………400
Prepaid insurance……………………………………….150
Office equipment……………………………………11,600
Truck……………………………………………….550, 000
Accounts payable…………………………………………………….Birr 12,430
Nots payable……………………………………………………………..150,000
Yimer capital……………………………………………………………..449,500
Total……………………………………Birr 611,930 Birr 611,930

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