CHAPTER TWO

ACCOUNTING CYCLE FOR

SERVICE-GIVING BUSINESS

1
 Learning Objectives
• After completing this chapter, students will able to;
– Understand Accounting cycle and its steps
– Define Account, chart of account and understand its
classifications
– Understand the rule of debits and credits
– Prepare Unadjusted Trial balance
– Prepare Adjusting entries
– Prepare Worksheet
– Prepare financial statement from the worksheet
– Prepare Closing entries
– Prepare Post closing Trial balance

2
 ACCOUNTING CYCLE
• The accounting cycle is process or a series of activities
that begins with a transaction and ends with the closing of the
books.
• Because this process is repeated each reporting period, it is
referred to as the accounting cycle.
• includes the following major steps
1. Identify and Analyze the transaction and events
2. Recording transactions and events in a journal
3. Classifying transactions by posting from the journal to
accounts in the ledger
4. Summarizing transactions from the ledger to an
unadjusted Trial balance
 Cont…d
5. Prepare necessary adjusting entries
6. Prepare the adjusted trial balance (completion of the
work sheet)
7. Summarize worksheet data in the form of financial
statement
8. Closing the accounting records (nominal accounts) to
summarize operations of the accounting period.
9. Preparation of post-closing trial balance.
10. Reversing certain adjusting entries (optional)
• The steps from 1-4 are performed throughout the
accounting period as transactions occur or in periodic
batch processes. The steps from 5-10 are performed
at the end of the accounting period.
 Characterstics of an Account

• A service giving companies produces and sells

intangible benefits or utilities to customers.
• Accounting systems are designed to show the
increases and decreases in each financial statement
item in a separate record. This record is called an
account.
• A group of accounts for a business entity is called a
ledger.
• A list of the accounts in the order in which they
appear in the ledger is called a chart of accounts.
 Cont…d
• An account, in its simplest form, has three parts.
 First, each account has a title, which is the name of the item
recorded in the account.
 Second, each account has a space for recording increases in
the amount of the item.
 Third, each account has a space for recording decreases in
the amount of the item.
 The account form is called a T-account because it resembles
the letter T.
• The terms debit and credit mean left and right sides
respectively.
• The left side of an account is called the debit side and the
right side of an account is called the credit side.
 Classification of Accounts
• Customarily accounts in a ledger are classified according to
common characteristics.
I. Statement of financial position accounts are classified
as assets, liabilities, and equity.
II. Statement of profit or loss and other comprehensive
income accounts are classified as income and expenses
1. Assets
• A resource controlled by an entity as a result of past events
and from which future economic benefits are expected to
flow to the entity.
• Assets are customarily divided in to two groups for
presentation on the Statement of financial position
 Cont…d
a) Current assets
• An asset should be classified as a current asset when
it is expected to be realized in, or is held for sale or
consumption in the normal course of the entity's
operating cycle; or is held primarily for trading
purposes or for the short-term and expected to be
realized within twelve months of the end of the
reporting period; or is cash or a cash equivalent asset
which is not restricted in its use.
• The operating cycle of an entity is the time between
the acquisition of assets for processing and their
realization in cash or cash equivalents.
 Cont…d
• Cash: is any medium of exchange that a bank will accept
at face value. Such as; bank deposits, currency, checks,
bank drafts, and money orders.
• Notes receivable: are claims against debtors evidenced
(backed) by a written promise to pay a sum of money at
a definite time to the order of specified person or bearer.
• Accounts Receivable: are also claims against debtors,
but less formal than notes. Accounts receivables arise
from sales of services or merchandise on account.
• Prepaid expenses: include supplies on hand and
advance payments of expenses such as insurance and
property taxes.
 Cont…d
b) Non-current assets: include tangible, intangible,
operating and financial assets of a long-term nature.
• Other terms with the same meaning can be used (eg
'fixed', 'long-term').
• Plant Assets are tangible assets that: are held for use
in the production or supply of goods or services, for
rental to others, or for administrative purposes; and
are expected to be used during more than one period.
• Plant assets include equipment, machinery, buildings,
and land. Such assets, except land gradually wear out
or otherwise lose their usefulness with the passage of
time.
 Cont…d
2. Liability
• A present obligation of the entity arising from
past events, the settlement of which is expected
to result in an outflow from the entity of
resources embodying economic benefits.
• They are frequently described on the Statement
of financial position by titles that include the
word “payable”.
• The two main categories most often used are.
– current liabilities and
– Long term liabilities
 Cont…d
a) current liability-is expected to be settled in the
normal course of the entity's operating cycle or
held primarily for the purpose of trading.
b) Long-Term liabilities – Liabilities that will not be
due for a comparatively long term (usually more
than one year) are called long-term liabilities or
fixed liabilities.
• Such liabilities become current liabilities as they
due within one-year range.
 Cont…d
3. Equity
• It is the residual interest in the assets of the entity after
deducting all its liabilities. For a corporate type of
business owner’s equity is frequently called stockholders’
equity, shareholders equity, or stockholders investment.
• Capital is the owner’s equity in a sole proprietorship
(and partnership).
• The owner’s equity may also be described as net worth.
For a corporation,
• Share capital represents the investment of the
stockholders’.
• Retained earnings constitute accumulated profits (less
losses) made by the company and can be distributed to
shareholders as dividends.
 Cont…d
• Drawings represent the amount of
withdrawals made by the owner of a sole
proprietorship (and partnership).
• Dividends represent the distribution of
earnings to stockholders For corporation, .
 Cont…d
Performance
• Profit is used as a measure of performance, or as a basis
for other measures (e.g. Earnings per share).It depends
directly on the measurement of income and expenses.
4) Income
• Income is increases in economic benefits during the
accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that
result in increases in equity, other than those relating to
contributions from equity participants
• Both revenue and gains are included in the definition of
income.
• Revenue arises in the course of ordinary activities of an
entity.
 Cont…d
• Revenue is the gross inflow of economic benefits during the
period arising in the course of the ordinary activities of an entity
when those inflows result in increases in equity, other than
increases relating to contributions from equity participants.
• Gains Increases in economic benefits. As such they are no
different in nature from revenue. It arises from extra ordinary
activities of business
• Eg. Gain on the disposal of non-current assets.
5. Expenses
• Expenses are decreases in economic benefits during the
accounting period in the form of outflows or depletions of assets
or incurrence of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants.
• Expense includes losses as well as those expenses that arise in
the course of ordinary activities of an entity.
• Losses Decreases in economic benefits.
 Chart of Accounts
• A listing of the accounts in a ledger is called a chart of
accounts.
• The number of accounts maintained by a specific
enterprise is affected by the nature of its operations, its
volume of business, and the extent to which details are
needed for taxing authorities, managerial decisions, etc.
• Each account number has at least two digits.
• The first digit indicates the major division of the ledger in
which the account is placed. Accounts beginning with 1
represent assets; 2, liabilities; 3 owner’s equity (owner’s
capital and drawing); 4, revenue; and 5 expenses.
• The second digit indicates the position of the account
within its division.
 Rules of Debits and Credits
Financial position Accounts
• Each business transaction affects a minimum of two
accounts in a financial statements of that business.
• In a basic accounting equation, A = L + O.E the equality
of debit and credit for each transaction are always
maintained.
• Because of its duality such a system is known as
double-entry account.
• As per the general rules of debit and credit, the debit is
a left hand side, whereas, a credit is the right side of
all accounts whether asset, liability, or owners equity.
• The term debit and credit do not mean increase or
decrease (it is simply left or right).
 Cont…d
• a debit and credit may be either an increase or
a decrease, depending on the nature of
accounts affected.
• For each transaction debits equal to credits
and every transaction affects at least two
accounts.
Debit may signify Credit may signify
Increase in asset accounts Decrease in asset accounts
Decrease in liabilities accounts Increase in liability
Decrease in owner’s equity accounts
accounts Increase in owner's equity
accounts
 Cont…d
• Performance Accounts
• The principle of debit and credit in its application
to Income and expense accounts is based on the
relationship of these accounts to owner’s equity.
• Income increases owner’s equity.
• The same to as increases in owner’s equity are
recorded as credits; increases in Income during an
accounting period are recorded as credits.
• Expenses have the effect of decreasing owner’s
equity, similarly, just as decreases in owner's
equity are recorded as debits; increases in
expense accounts are recorded as debits.
 Normal Balances of Accounts

• The sum of the increases recorded in an account is usually equal to or greater

than the sum of the decreases recorded in the account.
• Is increasing side of accounts or the side (Dr or Cr) that increase the
account.
Increase Decrease Normal Bal.
Balance
Financial position Accounts:
Assets Debit Credit Debit
Liabilities Credit Debit Credit
Owner’s Equity or Stockholders Equity:
Capital/Capital Stock Credit Debit Credit
Retained Earnings Credit Debit Credit
Drawing/Dividends Debit Credit Debit
Performance Accounts:
Income Credit Debit Credit
 Step 1 & 2: Analyzing and recording transactions

• Every business transaction affects at least two

accounts.
• The transaction in the organizations occurred
after authorized by the manager or the
employees.
• After the business transaction occurred it should
be evidenced by a business documents (which
become the basis for analyzing and recording
the transaction)
 Cont…d
• On the basis of the evidence provided by the
business documents, the transactions are
entered in chronological order on a journal.
• Thus, the journal is referred to as the book of
original entry and for each transaction the
journal shows the debit and credit effects on
specific accounts.
• The process of recording a transaction in the
journal is called journalizing.
• Depending on the types and volume of
business transactions, a business may use a
single all purpose two-column journal, or it
may use a number of multicolumn journals,
limiting each to single types of transaction.
 Cont…d
• The process of recording a transaction in
a two-column journal
1. Record the date: YY/MM/DD
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 debit column
3. Record the credit:-Insert the title of the
account to be credited below 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, moderately
indented.
 Cont…d
• Before a transaction entered in the two-column journal,
it should be analyzed according to the following
sequence of steps.
a. Determine whether an asset, a liability, owner’s equity,
revenue, or expense affected.
b. Determine whether the affected asset, liability, owner’s
equity, revenue, or expense increases or decreases.
c. 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.
 Step 3: Classifying transactions from the journal to accounts in the ledger

• The procedure of transferring journal entries to the

ledger accounts is called posting.
• When posting is done manually, all the debits may
be posted first, followed by the credits.
• The posting of a debit journal entry or a credit
journal entry to an account in the ledger is done in
the following manner:
I. Record the date and the amount of the entry in
the account.
II. Insert the number of the journal page in the
posting reference column of the account.
III. Insert the ledger account number in posting
reference column of the journal.
 Illustration
• Hamle1. Alem Taye operated a Dry cleaning business
known as “Alem Dry Cleaner” on Hamle 2014. She was
invested the following assets in the enterprise: Cash
Birr 11,000; accounts receivable, birr 17,100; supplies
Birr 4,400 and Dry Cleaning in Equipment birr 47,000.
There were no liabilities transferred to the business.
• Hamile1. Paid Birr 5,400 on a rent contract represent
three months rent of the quarters for the business
• Hamle3. Purchased additional Dry cleaning Equipment
on account from National Equipment Co. for Birr 9,000
• Hamle4. Received Birr 7,100 from customers in
payment of their accounts
• Hamle5. Paid Birr 1,500 for a television advertisement
 Cont…d
• Hamle 9. Paid birr 4,000 to National Dry Cleaning
company to apply on the Birr 9000 debt owed to them
• Hamle13. Paid Birr 470 a two weeks salary for the
receptionist
• Hamle16. Received Birr 5,845 from sales for the first
half of Hamle
• Hamle19. Paid Birr 2,900 for supplies
• Hamle27. Paid Birr 470 a two weeks salary for the
receptionist
• Hamle30. Paid Birr 367 for electric, telephone, and
water bills for a month
• Hamle30. Received Birr 5,735 from sales for the
second half of Hamle
• Hamle30. Sales on account totaled Birr 3,925.
• Hamle30. Alem withdrew Birr 2,500 for her personal
use.
 Step 4: Preparing a Unadjusted Trail Balance

• A trial balance is a list of accounts

and their balances at a given time.
• It is prepared at the end of an
accounting period and used to verify
the equality of debits and credits in
the ledger.
• The primary purpose of a trial
balance is to prove the mathematical
equality of debits and credits after
posting.
 Alem Dry Cleaners
Trial Balance
Hamle 30, 2014

Dr Cr
Cash 12073
Accounts receivable 13925
Supplies 7300
Prepaid rent 5400
Dry-cleaning 56000
equipment
Accounts payable 5000
Alem Taye, capital 79500
Alem Taye, Drawing 2500
Sales 15505
Salary expense 940
Miscellaneous 1867
 Cont…d
Proof Provided by the Trial Balance
• Preparing the trial balance is one of the primary ways
to discover errors in the ledger.
• However the trial balance does not assure a complete
proof of the accuracy of the ledger.
• It is simply a test of the equality of debits and credits
in a ledger. The following types of errors may cause a
trial balance not to balance;
1. Error in the preparation of the trail balance:
– One of the columns of the trial balance was
erroneously computed
– The amount of an account balance was wrongly
recorded on the trial balance
– A debit balance was recorded on the trial balance as
a credit, or vice versa, or a balance was omitted
entirely.
 Cont…d
2. Error in determining the account balances,
such as:
– Incorrect computation of a balance
– A balance was entered in the wrong
balance column
3. Error in recording a transaction in the
ledger, such as:
– An incorrect amount was posted to the
account
– A debit entry was posted as a credit, or
vice versa
– An omission of a debit or a credit posting
 Cont…d
• Numerous errors may exist even though the
trial balance columns are in-balance i.e. there are
errors that will not cause the trial balance totals
to be unequal. Such as, the trial balance may
balance even when:
1. Failure to record a transaction or to post a
transaction (complete omission).
2. Recording the same erroneous amount for
both the debit and the credit parts of a
transaction.
3. Recording the same transaction more than once.
4. Posting a part of a transaction correctly as a
debit or credit but to the wrong account.
 Cont…d
• Other common types of errors
occurred while Jor/Pos
transactions;
1. Omission
2. Transposition occurs when the order of the digits
is changed mistakenly, such as writing Birr 542 as
Birr 452 or Birr 524.
3. Slide, the entire number is mistakenly moved one
or more spaces to the right or the left, such as
writing Birr 542.00 as Birr 54.20 or Birr 5,420.00.
 Step 5. Preparing Adjusting
entries
• Adjusting entries are journal entries usually
made at the end of an accounting period
to allocate income and expenses to the period
in which they actually occurred.
• The revenue recognition principle is the basis
of making adjusting entries that pertain to
unearned and accrued revenues under
accrual-basis accounting.
• Based on the matching principle of
accrual accounting, revenues and associated
costs are recognized in the same accounting
period. However the actual cash may be
received or paid at a different time.
 Types of adjusting entries

Elements of adjustment
Items Prepayments ( Accrual - cash
Deferral - cash paid or paid or received
received before after consumption
consumption)
Expenses Prepaid expenses: Accrued
/Asset/ for expenses paid in expenses: for
liabilities cash and recorded as expenses incurred
assets before they are but not yet paid in
used cash and not yet
recorded
Revenues Unearned revenue: Accrued
/Asset/ for revenues received revenues: for
Liabilities in cash and recorded revenues earned
as liabilities before but not yet
Summary
Summary of
of Basic
Basic Adjustments
Adjustments
 Adjusting entries elements
I) Prepayments
• Adjusting entries for prepayments are necessary
to account for cash that has been received prior
to delivery of goods or completion of services.
• When this cash is paid, it is first recorded in a
prepaid expense asset account; the account
is to be expensed either with the passage of
time (e.g. rent, insurance) or through use and
consumption (e.g. supplies).
• A company receiving the cash for benefits yet to
be delivered will have to record the amount in an
unearned revenue liability account. Then, an
adjusting entry to recognize the revenue is used
as necessary.
 Examples:
1. As per Alem’s trial balance, the balance in the
supplies account on Hamle 30 is Birr 7,300.
Assuming that the inventory of supplies on Hamle
30 is determined to be Birr 5,000. the amount of
supplies used (transferred to expense account) is
computed as follows:
Supplies available (balance of account).........Birr
7,300
Supplies on hand (inventory) ............. 5,000
Supplies used (amount of adjustment).................
Birr 2,300
Adjusting entry
Supplies expense 2,300
Supplies 2,300
 Con’t.…d
2. Alem’s prepayments for rent covering for three
months have a debit balance of Birr 5,400 on Hamle
1. At the end of Hamle, the portion belongs to
Hamle is one-third (1/3) of the total balance of
prepaid Rent. Thus the rent expense account should
be increased (debited) and the prepaid rent account
should be decreased (credited) by Birr 1800.
Adjusting entry
Rent expense 1800
Prepaid rent 1800
3. The estimated amount of depreciation for the
month is assumed to be Birr 4,500.
Adjusting entry
Ham 30 Depreciation Expense 4,500
Accumulated Depreciation 4,500
If Adjusting entry didn’t prepared for
prepayment
Effects on financial statements
– Statement of profit or loss
Expenses will be understated........ Birr
8,600
Net income will be overstated ....
8,600
– Statement of Owner’s Equity
Net income will be overstated........ Birr
8,600
Ending owner’s equity will be overstated
by 8,600
– Statement of Financial Position
 Con’t….

II) Accruals
• Accrued revenues are revenues that have
been recognized (that is, services have been
performed or goods have been delivered), but
their cash payment have not yet been
recorded or received.
• When the revenue is recognized, it is recorded
as a receivable.
• An income which has been earned but it has
not been received yet during the accounting
period. Incomes like interest on investments,
commission etc. are examples of accrued
income.
• Accrued expenses have not yet been paid
 Example
• The debits of Birr 470 on Hamle 13 and
27 in the salary expense account were
biweekly payments on alternate Fridays
for the payroll periods ended on those
days. The salaries earned on Monday
and Tuesday, Hamle 29 and 30, total
Birr 94.
Adjusting entry
Ham 30 Salary expense 94
Salaries payable 94
 Step 6 & 7: Preparing Work sheet
• 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 main purpose of a worksheet is that it reduces
the likelihood of forgetting an adjustment and it
reveals arithmetic errors.
• A worksheet acts as a tool for an accountant and
it is not usually intended to be used by third
parties. It is an informal document.
• 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: Trial
Balance, Adjustments, Adjusted
Trial Balance, Income Statement,
and Balance sheet.
 Step 8. Preparing Closing Entries
• The Revenue, Expense, Drawing (dividend) accounts
are 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
accounts 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.
• It is used only at the end of the accounting period
and is both opened and closed in the closing
process.
 Cont’d
• Four entries are required in order to close
temporary accounts of a sole proprietorship at
the end of a period:
1) To close all revenue accounts: Each
Revenue account is debited for the amount of its
balance, and Income Summary is credited for the
total revenue.
Revenue xxx
Income Summary xxx
2) To Close all expense accounts: Each
expense account is credited for the amount of its
balance, and Income Summary is debited for the
total expense.
Income Summary xxx
Expense xxx
 Cont’d
3) To Close the Income Summary
account: 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) To close the drawing account: The
drawing account is credited for the amount
of its balance, and the capital account is
debited for the same amount. The same is
true for dividend account, dividend account
is credited for its balance and Retained
Earnings is debited for the amount
 Step 9) Post-Closing Trial Balance

• A post-closing trial balance is a list of balances

of ledger accounts prepared after closing
entries have been passed and posted to the
ledger accounts.
• Since the closing entries transfer the balances
of temporary accounts (i.e. expense, revenue,
gain, dividend and withdrawal accounts) to the
retained earnings account, the new balances of
temporary accounts are zero and therefore they
are not listed on a post-closing trial balance.
• However, all the other accounts having non-
negative balances are listed including the
retained earnings account.
 Cont’d
• The preparation of post-closing trial
balance is the last step of the
accounting cycle and its purpose is
to be sure that sum of debits equal
the sum of credits before the start of
new accounting period.
• It provides the openings balances for
the ledger accounts of the new
accounting period.
THIS IS ALL!

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