CHAPTER 3

The Accounting Cycle for Service Enterprises

Recording transactions under columnar headings as we did in chapter 1 is very messy and
inefficient. Instead, accountants have developed a system by which the effects of
transactions and events may conveniently be recorded, sorted, summarized, and stored
until financial statements are desired. That system is the focus of this chapter

The accounting cycle is a series of steps performed during the accounting period to
analyze, record, classify, summarize, and report useful financial information for the
purpose of preparing financial statements.

The accounting cycle is the sequence of accounting procedures during a fiscal period. It
consists of the following 8 Steps:
1. Analyze and Record Transactions in 4. Preparing Financial Statements
a Journal 5. Adjusting and Closing Entries
2. Post from the Journal to the Ledger Journalized
3. Trial Balance Prepared, Adjustment 6. Post Closing and Adjusting Entries
Data Assembled, and Worksheet 7. Prepare Post-Closing Trial Balance
Completed 8. Reversing Entries(Optional)

1. Meaning and Uses of an Account

An account is an individual (separate) accounting record of increases and decreases in a

specific asset, liability, owner’s capital, revenue, or expense item. For example, in Smart
Software Co. (discussed in chapter 2) there would be separate accounts for Cash, Accounts
Receivable, Accounts Payable, Loan Payable, Rent expense etc.

Accountants may differ on the account title (name) they give for the same item. Having
separate accounts enables to accumulate in one place all the information about changes in each
financial statement item and this facilitates quick and easy retrieval of data, whether manual or
computerized.

In its simplest form (T-account) an account consists of three parts:

Title of Account

“Left” sideDebit Credit “Right” side

The terms debit and credit are directional signals: Debit indicates left, and credit indicates
right. Thus, the debit side of any account is always the left side and the credit side of any
account is always the right side. Entering an amount on the left side of an account is called
debiting (charging) the account; making an entry on the right side is crediting the account.

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 The positioning of debits on the left and credits on the right is simply an accounting custom,
similar to the custom of driving on the right-hand side of the road.

Q. Which side is used to record increases and decreases?

Classification of Commonly Used Accounts

Balance sheet Accounts:

1. Asset:
Assets are something of value the company owns. They can be tangible or intangible.
 Tangible Assets are generally divided into three major categories:
i) Current assets: typically include cash and assets the company reasonably expects to
use, sell, or collect within one year. Current assets appear on the balance sheet in the
order of liquidity, from most liquid to least liquid. Liquid assets are readily convertible
into cash or other assets, and they are generally accepted as payment for liabilities.
a. Cash -- cash on hand and in the bank
b. Marketable securities- include short-term investments that the company has both
the ability and the desire to sell within one year.
c. Notes receivable-claims against debtors evidenced by written promise to pay a
sum of money at a certain date. It may arise: when sale is made and a note is
received, when a customer gives a note for an amount due on A/R, when money
is loaned and a note is received as evidence
d. Accounts receivable-- amounts due from customers for goods or services
provided. It is less formal than note because no written promise is made (except
his signature)
e. Prepaid expenses -- are items that have been paid for but not yet used. Examples
include office supplies, insurance premiums, and advance payments for rent.
These assets become expenses as they expire or get used up.
ii) Property, plant, and equipment (fixed assets)-- cost of long-lived assets purchased
and used in business. Examples include land, buildings, production equipment,
vehicles, and office furniture. With the exception of land, all are depreciable.
iii) Long-term investments – are investments the company intends to hold for more than
one year or are not marketable.
 Intangible Assets-- lack physical substance, but they may, nevertheless, provide
substantial value to the company that owns them. E.g., patents, copyrights, trademarks

2. Liabilities:
Liabilities are the company's existing debts and obligations owed to third parties.
 Liabilities are generally classified as:
i) Short-term (current)
 Obligations that will be repaid within one year of the balance sheet date. The sooner a
liability must be paid, the earlier it is listed.
 Examples are: Accounts payable, Wages payable, Notes payable (short-term), Interest
payable
ii) Long-term liabilities

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  Obligations that will not be repaid within one year from the balance sheet date
 The portion of liability that will be paid during one year will be current liability ( e.g
payment to be made on installment)
 Examples are: mortgage payable - when a note is accompanied by security in the form
of mortgage, Bonds payable
3. Owner's Equity:
Residual claim of owners, computed as “assets minus liabilities”
For Sole Proprietorship and Partnership:
 Owner’s equity is represented by single account-- Capital preceded by the name of the
owner(s).
 It equals the total net investment (investment less withdrawal) plus the net income or loss.
For a Corporation:
 The owners’ equity section is called stockholders’ equity.
 SHE is comprised of:
Capital stock-- representing investment of the stockholders
REs - representing income retained in the business

Remember the effect of withdrawals (dividends) on owner’s (stockholders’) equity.

Income Statement Accounts:
1. Revenues:
It is inflows of assets from providing goods or services to other economic entities. It may arise
from different sources, and are identified by various names depending on the nature of the
business. E.g Fees earned, Rent earned, Professional fees, Sales revenue, Commission revenue,
Interest income etc.

If an enterprise has various types of revenue, a separate account should be maintained for each.
Remember revenues increase owner's equity.

2. Expenses:

 Cost of items and services used to produce revenue

 Like revenues, expenses take many forms and are identified by various names depending on
the type of asset consumed or services used. e.g Salary expense, Advertising expense, Supplies
expense, Rent expense, Interest expense etc.
 A separate account should be maintained for each type of expense.
 Remember expenses decrease owner's equity

Chart of Accounts

 A chart of accounts is a list of all the accounts that a business uses along with their account
number.  It can be compared to a table of contents. The numbering system usually starts with
the balance sheet accounts and follows with the income statement accounts.
 A sole proprietorship may have few accounts and use a two or three digits account numbers.
Under a two digit chart of accounts the first digit indicates the major division of the ledger. The
second digit indicates the position of the account within the division. Under a three digit chart

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 of accounts the first digit represents the accounts classification (1 for assets, 2 for liabilities).
The second digit represents the sub-classification (11 for current assets, 21 for CLs). The third
digit represents specific accounts.
 But a multinational corporation may have thousands of accounts and use ten- or even twenty-
digit numbers to track accounts by location, department, project code, and other categories.
 The accounts should be numbered to permit indexing and for use as a references.
2. The Accounting Cycle
 It starts with analysis and recording of transactions

Step 1 Analyzing and Recording Transactions

 Remember that in chapter 1 we saw each business transaction affects at least two items
(accounts). The increases and decreases were recorded using plus/minus procedure. But in this
chapter we will use debits and credit and the double entry procedure.
2.1 The Account and Rules of Debit and Credit
 Double entry accounting is the system that records transactions based on their dual effect in
terms of debits and credits which are equal in amount. If a company records every transaction
with equal debits and credits, then the sum of all the debits to the accounts must equal the sum
of all the credits. This equality gives to the accountant some assurance that the arithmetic part
of recording the transaction process has been properly carried out.

2.2 Applying the Double-Entry System

Recoding Changes in Balance Sheet Accounts:
 Every business transaction is analyzed in to its increasing and decreasing effect on the
accounting equation elements. Remember the Accounting Equation:
Assets = Liabilities + Owners' Equity
 In recording business transactions in the T-accounts, think first of the equal sign in the
accounting equation.
 Assets are to the left of the equal sign and are increased on the left side of the T-account.
Liabilities and OE are to the right of the equal sign and are increased on the right side of the T-
account. You already know that the left side of the T-account is the Dr. side and the right side
of the T-account is the Cr side
 So Assets (accounts on the Left side) will INCREASE with a Debit entry.
Liabilities and OE (accounts on the right side) will INCREASE with a Credit entry.
They will each DECREASE with the OPPOSITE entry.

Assets = Liabilites + Owner's equity

Dr. for Cr. for Dr. for Cr. for Dr. for Cr. for
Increases Decreases Decreases Increases Decreases Increases

E.g. Jan. 1 Ato Sira deposited Br.30,000 in the company’s bank account .

Dr. Cash Cr. Dr. Sira, Capital Cr.

Jan1 30,000 30,000 Jan.1

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 Jan. 2 Purchased supplies of flash disks, stationery etc for Br.9,000 on credit
Dr. Supplies Cr. Dr. Accounts Payable Cr.
Jan2 9,000 9,000 Jan.2

Basic equation Assets = Liabilities + Owner’s equity

Expanded Basic Assets = Liabilities + Owner’s capital + Revenues – Expenses - Drawings

Equation
Dr. Cr. Dr. Cr Dr. Cr Dr. Cr Dr. Cr Dr. Cr
Debit / Credit +   +  +  + +  + 

 Revenues, expenses, and drawings/dividends are sub-classification of the OE. The debit and
credit rules for recording these items are based on the rules for recording changes in owner's
equity.
 In chapter 1 we recorded these items directly in owner’s capital account. However, this
procedure is not done in practice. In stead, separate records (accounts) are maintained which
gives a clearer information for these items and facilitate the preparation of financial statements
and different decisions.
Recording Changes in Income Statement Accounts
 Revenues increase OE and just as increases in OE are recorded as Crs, increases in revenue are
recorded as credits. Decreases are recorded on the opposite, Dr., side.
 Expenses have a decreasing effect on OE, and just as decreases in OE are recorded as Drs.
increases in expense account are recorded as debits. Decreases are recorded on the opposite,
Cr., side.
E.g. Jan. 7 Received Br.15,000 in fees for software developed for a small retail store.
Dr. Cash Cr. Dr. Prof. Fees Cr.
Jan.1 30,000 150,000 Jan.7
Jan.7 15,000

Jan.31 Paid salary for employees, Br 6,000

Dr. Cash Cr. Dr. Salary Expense Cr.
Jan.1 30,000 Jan.31 6,000
Jan.7 15,000 6,000 Jan.31

Recording Drawings and Dividends

 Both have decreasing effect to OE
 And just as decreases in OE are recorded as debits, increases in withdrawals and dividends are
recorded as debits. Decreases are recorded on the opposite, Cr., side.

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 E.g. Jan.29 Ato Sira withdrew cash of Br.4,000 from the company and bought a TV set for
his family.
Dr. Cash Cr. Dr. Sira, Drawing Cr.
Jan1 30,000 6,000 Jan 31 Jan.29 4,000
Jan 7 15,000 4,000 Jan.29
 Note that the separate accounts for revenues, expenses, and drawings/dividends are maintained
only temporarily. At the end of the accounting period revenue and expense account balances
are transferred to owner’s capital or REs and are said to be closed. Thus, these accounts are
called temporary (nominal) accounts.
Determining the Balance of an Account
 Periodically, the accounts are totaled to arrive at balances. For each account, the amounts
entered on the debit side are totaled, and the amounts entered on the credit side are separately
totaled. The difference between these two totals is the account’s balance; the balance appears
on the side that has the greater total.
E.g. If all the transaction of Smart Software Co. were recorded, we would have the following
result for the account ‘Cash’.
Cash

Jan.1 30,000 12,000 Jan.5

Receipts of Jan.7 15,000 5,000 Jan.13
cash Jan.18 12,000 5,100 Jan.27 Payments of cash
57,000 4,000 Jan.29
6,000 Jan.31
32,100
Balance Br.24,900
 When the debit amounts exceed the credits, an account has a debit balance; when the reverse
is true, the account has a credit balance.
Normal Balance of Accounts
 The sum of increases recorded in an account is usually equal to or greater than the sum of the
decreases recorded in account. For this reason, the normal balances of all accounts are positive
rather than negative.
 Since assets, expenses, and drawing/dividend accounts are increased by debits, they normally
have debit (left-side) balances. Conversely, liabilities, Owner’s capital and Revenue accounts
are increased by credits and normally have credit (right-side) balances
 If the account has a balance opposite its normal balance, we say the balance is negative, in
relation to what it should be. Negative in this sense does not refer to debits or credits, but to a
normal or negative balance, regardless of whether that is a debit or credit balance.
 An account can have negative balance if:
a) There are accounting errors at time of journalizing, posting or calculating the
account balance. For example, a credit balance for Land account, a debit balances in a
liability account unless it results from an overpayment. So knowing the normal
balance in an account may help you trace errors.
b) There are some special or unusual conditions. E.g. a credit balance in Cash account
when a company has overdrawn its bank balance(OD)

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 2.3 Recording Transactions in the General Journal
Flow of Accounting Data
 The flow of accounting data from the occurrence of a transaction to its recording in the ledger
may be diagramed as follows:
Business transactions Business document Entry recorded Entry posted to
Occur  prepared in journals ledger

 The recording process begins with the transaction. Business (Source) documents, such as a
sales slip, a check, a bill, carbon copies of receipts and payments, or a cash register tape,
provide evidence of the transaction. The company analyzes this evidence to determine the
transaction’s effects on specific accounts. The company then enters the transaction in the
journal. Finally, it transfers the journal entry to the designated accounts in the ledger.

Journal:
 In explaining the rules of debit and credit we rerecorded transactions directly in the accounts.
But this is not what we practically do. This is because all the effects of a single business
transaction would not appear in only one account. For example, the account cash shows
increases and decreases in cash not how the cash was generated or spent.
 Transactions are initially recorded in a journal before they are entered into an account. As a
result a journal is referred to as a book of original entry.
 Though we have various kinds of journals, we will see the most basic form of journal, a
general journal (also called two-column journal). Its standard format is given below:
Page No.___
Pos.
Date Description Ref. Debit Credit

 It may be in the form of paper or may be a file on a computer disk or hard drive.
 To journalize or journalizing refers to the process of recording a transaction or event in a
journal
 Before transactions are recorded in a journal they should be analyzed in the following steps:
1. Identify what specific account was affected
2. Identify the account's group
3. Determine whether the account is increasing or decreasing
4. Apply the debit/credit rule
 After analysis transactions are recorded in the general journal in the following steps:
1. Record the date-- For convenience, include the year and month only at the top of each
page and next to each month's first entry.
2. Record the debit-- Insert the title of the account to be debited at the extreme left of the
description column and enter the amount in the Dr. Column
3. Record the credit-- Insert the title of the account to be credited below the debit entry,
moderately indented and enter the amount in the credit column. These practices are
used to make the journal entry easier to read, and reduce errors in posting.

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 4. Write an explanation-- You should also write a very short, but descriptive explanation
of the transaction on the third line of the transaction indented half way between the
accounts debited and credited. May be omitted if the nature of the transaction is
obvious
E.g. Jan. 1 Ato Sira deposited Br.30,000 in the company’s bank account.
Jan. 2 Purchased supplies of flash disks, stationery etc for Br. 9,000 on credit
GJ No. 1
Pos.
Date Description Ref. Debit Credit
2007
Jan. 1 Cash 30,000
Sira, Capital 30,000
To record investment by owner

2 Supplies 9,000
Accounts payable 9,000
To record purchase of supplies
 Journal entry is the form of presentation. Each general journal entry consists of four parts:
(1) the accounts and amounts to be debited (Dr.), (2) the accounts and amounts to be credited
(Cr.), (3) a date, and (4) an explanation.
o Compound journal entries (or complex journal entries)-- An entry that contains two or
more debits or two or more credits
o Simple journal entry-- an entry that contains only one debit and one credit
 Note the following:
o The titles used in the entries should be the same as the title of the accounts in the
ledger/chart of accounts
o NO dollar signs are used in the journal.
o The Posting Reference column is not used until debits and credits are posted to the ledger
 Advantages of using a journal:
i) It discloses in one place the complete effect of a transaction.
ii) It provides a chronological (the order in which they occur) record of transactions much
the same way as a personal diary is kept.
iii) It helps to prevent or locate errors because the debit and credit amounts for each entry
can be readily compared.
You can also see these advantages as the limitations of recording transactions directly in
accounts.

Step 2. Posting Entries from the Journal to the Ledger Accounts

The ledger:

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 The ledger is the entire group of accounts maintained by a company. It is also called book of
secondary entry.
 Companies arrange the ledger in the sequence in which they present the accounts in the
financial statements. First in order are the asset accounts, followed by liability accounts,
owner’s capital, owner’s drawing, revenues, and expenses.
 As is true for the journal, a general ledger may be in the form of paper or may be a file on a
computer disk or hard drive.
 Though we have various kinds of ledgers, we will see the most basic form of ledger, a general
ledger.
Posting:
 Posting is the procedure of transferring journal entries to ledger accounts. Posting accumulates
the effects of journalized transactions in the individual accounts.
 Standard form of a ledger account--The simple T-account form used in accounting textbooks
is often very useful for illustration purposes. However, in practice, the account forms used in
ledgers are much more structured. A standard four-column ledger account is as follows:
Cash A/C No. 11
Pos. Balance
Date Item Ref. Debit Credit Debit Credit

 Posting involves the following steps:

i) In the ledger, enter in the appropriate columns of the account(s) debited the date,
journal page, and debit amount.
ii) In the reference column of the journal, write the account number to which the debit
amount was posted.
iii) Perform the same steps in i. and ii. for the credit amount
 The use of the reference column in the journal serves two purposes. It allows for:
o Cross referencing between the journal and the ledger which facilitates tracing of
transactions from the journal to the ledger or vice versa at a later date.
o It indicates the completion of posting for the particular item.
 Posting can be made at the end of the day, week, month, etc
E.g. Post the journal entry on Jan. 1, 2007 to the appropriate ledger accounts.
Account Cash A/C No. 11
Pos. Balance
Date Item Ref. Debit Credit Debit Credit
Jan 1 GJ1 30,000 30,000

Account Sira, Capital A/C No. 31

Pos. Balance
Date Item Ref. Debit Credit Debit Credit
Jan 1 GJ1 30,000 30,000

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 Illustration
TO BE PROVIDED SEPARATELY.

Step 3. Preparing a Trial Balance

 Before preparing a trial balance for each account you must determine account balance.
 A trial balance is a list of accounts and their balances at a given time. They list accounts in the
order in which they appear in the ledger. Accounts with Debit balances appear in the left
column and those with credit balances in the right column.
 Unless there are errors in recording or posting entries, the dollar amount of total debits must equal
the dollar amount of total credits. Proving this equality is the primary purpose of the trial balance.
 But the equality does not guarantee that our work is error free.
 The trial balance is not a formal financial statement. Preparing the trial balance is a starting
point(a working paper) for organizing the information to be reported on a company's financial
statements
 Customarily, companies prepare a trial balance at the end of an accounting period. But it can
also be prepared everyday.
Errors Disclosed By a Trial Balance
 If a trial balance is out of balance, there is an error that must be corrected. The following types of
errors are disclosed by the trial balance as they affect the equality of total debit and total credit.
a) Error in preparing the TB, such as errors in: the addition of the TB columns; copying an
amount incorrectly to the TB; listing an account balance in the wrong column of the
TB(a Dr. balance as a Cr. balance or vice versa), or a balance was omitted entirely
b) Error in determining the account balances, such as: a balance was incorrectly
computed; a balance was entered in the wrong balance column
c) Error in recording a transaction in the ledger, such as: an erroneous amount was posted
to the account; a Dr. entry was posted as a Cr., or vice versa; a Dr. or a Cr. posting was
omitted.

Errors not disclosed by a trial balance (Limitations of a Trial Balance)

 A trial balance does not prove that all transactions have been recorded or that the ledger is
correct because the trial balance may still balance even if we have the following errors.
a) Failure to record a transaction or to post a transaction
b) Recording the same erroneous amount for both the debit and the credit parts of a
transaction
c) An entry is posted twice.
d) Recording the same transaction more than once
e) Posting a part of a transaction correctly as a debit or credit but the wrong account

Locating Errors
 The existence of errors in the accounts may be determined in various ways: by audit
procedures; by chance discovery; or through the medium of the trial balance.
 A trial balance that is out of balance indicates the existence of error(s).

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 To discover the error, first determine the amount of the difference between the two columns of
the trial balance. After this amount is known, the following steps are often helpful:
1. A difference of 10,100 or 1000 between two totals is frequently the result of an
error in addition. So re-add the trial balance columns and re-compute the account
balances.
2. If the difference is divisible evenly by 2, the error can be due to the posting of a
debit as a credit, or vice versa. For example, if the debit and the credit totals of our
trial balance are $25,775 and $28,175 respectively, the difference of $2,400 may
indicate that debit of $1,200 was erroneously posted as a credit.
3. If the difference is divisible by 9, then you most likely have a transposition error or
a slide error. A transposition is the erroneous rearrangement of digits, such as
writing $542 as $452. In a slide, the entire number is erroneously moved one or
more spaces to the right or the left, such as writing $542.00 as $54.2.
4. If the error is not divisible by 2 or 9, scan the ledger to see whether an account
balance in the amount of the error has been omitted from the trial balance, and scan
the journal to see whether a posting of that amount has been omitted.
 Of course, two or more errors can combine to render these techniques ineffective, and other
types of mistakes frequently occur. If the error is not apparent, return to the ledger and
recalculate each account's balance. If the error remains, return to the journal and verify that
each transaction is posted correctly.
Use of Dollar Signs
 Note that dollar signs do not appear in journals or ledgers. Dollar signs are typically used only
in the trial balance and the financial statements. Generally, a dollar sign is shown only for the
first item in the column and for the total of that column. A single line is placed under the
column of figures to be added or subtracted; the total amount is double-underlined to indicate
the final sum.

Accounting Cycle Step 3: Trial Balance Prepared, Adjustment Data Assembled, and
Worksheet Completed
Do we prepare financial statements based on the trial balance (unadjusted) we prepared
previously? No! Why? The trial balance may not contain up-to-date and complete data. This
occurs for the following reasons.
 Some events are not journalized daily because it is not expedient. Examples
are the consumption of supplies and the earning of wages by employees.
 Some costs are not journalized during the accounting period because these
costs expire with the passage of time rather than as a result of recurring daily
transactions. Examples are building and equipment deterioration and rent and
insurance.
 Some items may be unrecorded. An example is a utility service bill that will
not be received until the next accounting period
- Before preparing financial statements the company must analyze each account in
the trial balance to determine whether it is complete and up-to-date for financial
statement purposes.

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 The Adjustment Process
- Adjusting entries are made at the end of the accounting period so that revenues
are recorded in the period in which they are earned, and expenses are recognized in the
period in which they are incurred. In short, adjustments ensure that the company follows
the revenue recognition and matching principles.
- Thus, adjustments update both income statement and balance sheet items as of the
financial statement date. Adjusting entries are required every time financial statements
are prepared.
- Adjustments are internal, never involve cash.

Types of Adjusting Entries

- Adjustments fall into one of four categories: accrued revenues, accrued expenses,
unearned revenues, and prepaid expenses. Adjustments for unearned revenues and
prepaid expenses are related to multi-period items.

Accrued Revenues
- Revenues earned but not yet received in cash or recorded at the statement date.
Accrued revenues may accumulate with the passing of time as in the case of interest and
rent, or through services performed but for which payment has not been collected.
- Prior to adjustment, both assets and revenues are understated.
- The adjusting entry results in an increase (a debit) to an asset account and an
increase (a credit) to a revenue account.
Asset account ----------------- xx
Revenue account ---------- xx
- Without this adjusting entry, assets and owners’ equity on the balance sheet, and
revenues and net income on the income statement, are understated.

Accrued Expenses
- Expenses incurred but not yet paid or recorded at the statement date. These
expenses may include accrued interest, rent, taxes, and salaries.
- Prior to adjustment, both liabilities and expenses are understated.
- The adjusting entry results in an increase (a debit) to an expense account and an
increase (a credit) to a liability account.
Expense account ----------------- xx
Liability account ---------- xx
- Without this adjusting entry, total liabilities and total expenses are understated,
and owners’ equity and net income are overstated.

Prepaid Expenses
- Expenses paid in cash and recorded as assets before they are used or consumed.
Examples are office supplies, prepaid insurance, prepaid rent, prepaid advertising, and
depreciation.
- The prepayments are initially recorded as follows:

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 Prepaid Expense(Asset) ----------- xx
Cash --------------------------- xx
- At the end of each accounting period, adjusting entries are necessary to recognize
the portion of prepaid expenses that have become actual expenses through use(e.g
supplies) or the passage of time(e.g., rent and insurance).
- Prior to adjustment, assets are overstated and expenses are understated.
- So the adjusting entry results in a debit (increase) to an expense account and a
credit (decrease) to an asset account.
Expense Account -------------- xx
Prepaid Expense(Asset) ------ xx
- Without this adjustment, expenses are understated, but assets, net income and
owner’s equity are overstated on the financial statements.
- Depreciation is the process of allocating the cost of a long-lived asset (except
land) to expense over its useful life in a rational and systematic manner.
- The purchase of equipment or a building is viewed as a long-term prepayment of
services and, therefore, is allocated in the same manner as other prepaid expenses.
- Depreciation is an estimate rather than a factual measurement of the cost that has
expired.
- Depreciation under the simplest and most widely used methodStraight-lineis
computed as follows:
Depreciation Expense = Cost of the Asset  Salvage Value
Useful life
Where useful life refers the amount of time the asset is expected to be used in the business.
Salvage value refers the asset's worth at the end of its service life
- Since the original cost of a long-lived asset should always be readily identifiable,
a contra-asset account, accumulated depreciation (or allowance for depreciation), is used
to record the decrease in the usefulness of the asset.
Depreciation Expense ---------- xx
Accumulated Depreciation ----- xx
- A contra asset account offsets an asset account on the balance sheet. A contra-
asset account will have a normal balance on the side opposite to the normal balance of the
related asset account.
- In the balance sheet, Accumulated Depreciation is offset against the asset account.
Balance sheet:
Plant assets (at cost) ------------ xx
Less: Accum. depr. --------------------- (xx)
Carrying value -------------------- xx
The difference between the cost of the asset and its related accumulated depreciation is referred
to as the carrying value (book value or unexpired cost) of the asset
- Accounting records that do not include adjusting entries for depreciation expense
overstate assets, net income, and owners’ equity, and understate expenses.

Unearned Revenues

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 - Revenues received in cash and recorded as liabilities before they are earned. Such
items as rent, magazine subscriptions, tuition received prior to the start of a semester and
customer deposits for future service may result in unearned revenues.
- The advance collection from customers is initially recorded as follows:
Cash ------------------------------- xx
Unearned revenue (liability account) ----xx
- Unearned revenues are subsequently earned by rendering service to a customer.
- Prior to adjustment, liabilities are overstated and revenues are understated.
- Thus, the adjusting entry for unearned revenues results in a debit (decrease) to a
liability account and a credit (increase) to a revenue account.
Unearned revenue ----------- xx
Earned revenue ------------- xx
- If this adjustment is omitted, total liabilities will be overstated, and total revenues,
net income, and owners’ equity will be understated.

NB. Each adjusting entry affects one income statement account (a revenue or expense
account) and one balance sheet account (an asset or liability account).
Companies often prepare adjustments after the balance sheet date. However, they date
the entries as of the balance sheet date.

Use the following adjustment data for our illustration

1. The supplies account has a debit balance of $1,850. But physical count shows that the
company has supplies on hand worth of $890 as of March 31, 2007
2. The prepaid rent account has a debit balance of $2,400 which represents a payment for
three months beginning with March. But the prepaid rent for the month of March has
already expired as of March 31, 2007.
3. Depreciation of the photographic equipment for the month of March is estimated to be
$175.
4. Salaries accrued but not paid as of March 31, 2007 amount to $115.

Using a Work Sheet

Characteristics and Purposes of a work sheet

- Work Sheet is an informal multiple-column working paper (not a formal
statement) used by the accountant to organize data for the financial statements and lessen
the possibility of overlooking an adjustment.
- When a Work Sheet is used, it is not necessary to prepare a separate trial balance
because this is done on the first two columns of the work sheet.
- Once the accounts are all presented in the work sheet format, it makes it easier to
determine what accounts need to be adjusted.
- The use of a work sheet is optional. It is simply something done to make end-of-
period work easier and provide an arithmetical check on the accuracy of work. When a
work sheet is used, financial statements are prepared from the worksheet.

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 - Adjustments are journalized and posted from the work sheet after financial
statements are prepared. The work sheet is a useful tool as well to journalize the closing
entries.

Steps in Preparing a Work Sheet

- Taking the March 31, 2007 trial balance and adjustment data of Hill Photographic
Studio, we prepare the worksheet using the following steps.

Step 1: Enter the account titles and their unadjusted balances in the Trial Balance columns of
the work sheet, and total the amounts. Trial balance amounts are taken directly from ledger
accounts.

Step 2: Enter the necessary adjustments into the two adjustments columns. Be sure that debits
equal credits for each adjustment. It is common practice to use an identifying letter to relate the
debit to the credit of each adjustment. Remember that the purpose of adjusting entries is to
bring the accounts to their proper balances and to ensure that expenses are recorded in the
period that they are incurred and revenues are recorded when they are earned. If additional
accounts are needed for the adjusting entries, they are inserted on the lines immediately below
the trial balance totals. After the adjustments are entered, the adjustments columns need to be
added to determine at this point if there is an equal amount of debits and credits.

Step 3: Compute each account’s adjusted balance by combining the trial balance and
adjustment figures. Enter each account’s adjusted amount in the Adjusted Trial Balance
columns. Total adjusted trial balance columns and check for equality. Note that the accounts in
the adjusted trial balance contain all data that are needed for the preparation of financial
statements

Step 4: Extend (copy) the asset, liability, and owner’s equity amounts from the Adjusted Trial
Balance to the Balance Sheet columns. Copy the revenue and expense amounts to the Income
Statement Columns. Total the statement columns. But NOTE at this point they do not usually
BALANCE. There are three different situations:
 The income statement columns are equal, means that revenues equal
expenses and there is no net income or net loss. In this case there is no
change in owner’s equity.

 It the income statement credit column exceeds the debit column, the
difference represents net income for the period.

 It the income statement debit column exceeds the credit column, the
difference represents a net loss.
Net income is extended to the credit column of the balance sheet columns because net income
increases owner’s capital and owner’s capital increases on the credit side. (Net loss would be
extended to the debit column). The difference between the income statement columns and the
balance sheet columns should be the same.
- Note that the work sheet can be computerized using an electronic spreadsheet
program (Excel, for example) where formulas can be entered that will speed up the

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 process of preparing a work sheet to just a few minutes. A tremendous advantage of an
electronic work sheet is the ability to change data easily.

Accounting Cycle Step 4: Preparing Financial Statements

- The work sheet helps accountants prepare the financial statements. All figures for
the financial statements are on the work sheet. However, data in the financial statement
columns of the work sheet are not properly arranged for statement purposes.

Income Statement
- The accounts and balances in the work sheet's income statement columns transfer
directly to the income statement, which is prepared first.
- Remember that revenues (if more than one) and expenses are listed in the order of
magnitude (largest to smallest).

Owner’s Equity Statement

- Next, from the work sheet's balance sheet columns, use the owner's capital and
drawing account balances and the company's net income or loss (from the income
statement) to complete the statement of owner's equity.
- The amount shown for owner’s capital on the work sheet is the account balance
before considering drawings and net income (or loss). When there have been no
additional investments of capital by the owner during the period, this amount is the
balance at the beginning of the period.

Balance Sheet:
- Next, complete the balance sheet last. All figures for the balance sheet are on the
work sheet except the capital figure which is provided by the owner’s equity statement.
When preparing the balance sheet, be careful not to use the capital account balance on the
work sheet.
Note: We can also prepare financial statement directly from the adjusted trial balance

Accounting Cycle Step 5. Preparing and Posting Adjusting Entries

- Using a work sheet, financial statements can be prepared before adjusting entries
are journalized and posted. The adjustment data have been entered in the work sheet. But
a work sheet is not a journal, and it cannot be used as a basis for posting to ledger
accounts. So after financial statements are prepared, the adjustment data are recorded in a
general journal and posted to the ledger. This will bring the ledger into agreement with
the adjusted trial balance amounts shown on the worksheet.
- The adjusting entries are recorded on the next journal page following the page on
which the last daily transactions for the month are recorded(in our illustration assume it is
journal page no.2)

Accounting Cycle Step 6. Preparing and Posting Closing Entries

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 - Closing is the process of transferring the balances of temporary accounts to the
owner’s capital account, a permanent account.
 Temporary (Nominal) accounts are opened at the beginning of a period,
used to record events for that period and closed at the end of the period. They
accumulate data related to one accounting period only. When that period is
over, the balances of these accounts are summarized, and the information is
transferred to the owner’s capital account. They include all income statement
accounts and drawing/dividend.
 Permanent (real accounts) are those accounts that their balances are
carried forward from one accounting period to the next. Their ending balance
in one accounting period is always the starting balance in the subsequent
accounting period. They are all balance sheet accounts (assets, liabilities, and
owner’s capital).

- Closing entries serve two basic purposes.

 to return the balances of the temporary owners' equity accounts (revenue,
expenses, and drawings(or dividend) accounts) to zero so that these accounts
may be used to measure the activities of the next reporting period.
 to update the balance of the Capital (or Retained Earnings)account.

Recording the Closing Entries:

- The Work Sheet is very useful when preparing closing entries, because up-to-date
balances of all temporary accounts are clearly shown together in one place.
- In practice, companies generally prepare closing entries only at the end of a
company’s annual accounting period. However, to illustrate the journalizing and posting
of closing entries, we will assume that Hill Photographic Studio closes its books monthly.
- A temporary account, Income Summary, is used in closing revenue and expense
accounts to avoid the unnecessary detail of closing these accounts directly into the
owner’s capital account. This account is considered a “holding tank” for revenues and
expenses in the closing process until their effect is transferred (closed) to capital. (Hence,
the name Income summary). Is a clearing account - an account used to summarize (clear
out) the balances of other accounts. Income summary is used only at the end of the period
and is opened and closed during the closing process. Income summary does not have a
“normal” balance as other accounts do and will never appear on the financial statements.
- The closing entries are recorded on the next journal page following the page on
which the adjusting entries are recorded(in our illustration assume it is journal page no.2)
The four steps in the closing process:
- To close an account so that it will end up with a zero balance, you do the exact
opposite of what is in the account. To close an account with a credit balance, you make
an equal debit; to close an account with a debit balance, you make an equal credit.
Step 1 Close the balance of each Revenue account to the Income Summary account.

Revenue accounts(individually) ------ xx

Income Summary(total amount) -- xx

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Step 2 Close the balance of each Expense account to the Income Summary account.
Income Summary(total amount) --------- xx
Expense accounts(individually) ------ xx

Step 3 Close the balance of the Income Summary account to the owner’s capital account or, in
corporations, to the retained earnings account.

Now the ‘Income Summary’ account holds the net income (loss) for the period. (Remember:
Revenues – Expenses = Net Income (Loss)). However, this is only for a moment. We now
need to transfer net income/loss to the ‘Owner’s Capital’(REs in a corporation).

If income summary has credit balance(NI):

Income Summary ------------- xx
Capital(REs) --------------- xx

If income summary has debit balance(NL):

Capital(REs) --------------- xx
Income Summary ------------- xx
To confirm that all the revenue and expense accounts were properly closed(in step 1 and 2
above), compare the balance of the income summary account to the net income or net loss
amount on the Income Statement that was prepared for the company

Step 4 Close the balance of the owner’s Drawing (Dividend in a corporation) account to
the owner’s capital account(Retained Earnings).

Capital(REs) --------------- xx
Drawing(Dividend) ------------- xx

To confirm that all the accounts were properly closed, compare the balance in the owner’s
capital to the owner’s equity statement prepared for the company. The balance of the capital
account should agree with the final figure on the statement of owner’s equity.

Do not close Withdrawals (Dividends) through the Income Summary account. This is because
they are not expenses, and they are not a factor in determining net income/loss.

Accounting Cycle Step 7: Preparing Post-Closing Trial Balance

- Recall that a trial balance is prepared after entering the regular transactions of the
period, and that a second trial balance (the adjusted trial balance) occurs after posting the
adjusting entries. A company may take a third trial balance after posting the closing
entries.
- The trial balance after closing, called the post-closing trial balance, consists only
of asset, liability, and owners’ equity accounts—the real accounts.
- Its purpose is:

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  to make sure that the ledger is in balance at the start of the next accounting
period.
 to check the clerical accuracy of the closing entries
 to show that the accounting equation is in balance at the end of the accounting
period but does NOT prove that ALL transactions have been recorded or that
the ledger is correct (as would be the case with any type of trial balance).

The Accounting Cycle Summarized

- The principal accounting procedures of a fiscal period have been presented in this
and the preceding chapter. The sequence of procedures is frequently called the
accounting cycle. It begins with the analysis and the journalizing of transactions and ends
with the post-closing trial balance. The most significant output of the accounting cycle is,
of course, the financial statements.
- An understanding of all phases of the accounting cycle is essential as a foundation
of further study of accounting principles and the uses of accounting data by management.
To summarize, the cycle consists of the following steps:
1. Analyze and journalize transactions.
2. Post the journal entries to the general ledger accounts.
3. Prepare a trial balance, Collect adjustment data, and Complete the work sheet.
4. Prepare financial statements.
5. Journalize and post the adjusting entries.
6. Journalize and post the closing entries.
7. Prepare a post-closing trial balance.

Steps one and two occur as often as needed during an accounting period. Step three through
step five are end of period activities. In a busy office the trial balance may be prepared every
day. Step six and seven usually occur only at the end of each fiscal year, but these steps may be
completed at the end of each accounting period if the company chooses to do so.

Step 8 of the accounting cycle Reversing entries (optional procedure) will be discussed
in chapter 5 under accounting cycle for a merchandising firm.

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