CHAPTER 2

INFORMATION PROCESSING AND THE ACCOUNTING CYCLE

A well devised accounting system is a necessity for every business enterprise.

1. Recording and summarizing procedures

Recording:
There are established rules for recording transactions, the double entry system. It is called
double entry because equal debits and credit entries are made for every business transaction
or event.
Business transactions and other events cause changes in the assets, liabilities, or owners'
equity of business enterprise.
 Internal transactions occur within an entity, such as using buildings, and machinery in
its operations or transferring or consuming raw materials in production processes.
 External transactions involve interactions between an entity and its environment.
Journalizing:
Transactions and other events are not recorded originally in the ledger because a transaction
affects two or more accounts, each of which is on a different page in the ledger. So to
overcome this deficiency and to have a complete record of each transaction or other event in
place, a journal is employed.

Posting:
It is part of the summarizing and classifying process.
Trial balance:

It is a list of accounts and their balances at a given time.

The primary purpose of a trial balance is to prove the equality of debits and credits after
posting. It also uncovers errors in journalizing, posting, and preparation of financial
statements.

2. Year end accounting procedures

Adjusting entries:
The accrual basis of accounting requires that numerous adjustments are necessary before
financial statements are prepared. Adjustments are required to ensure that the revenue
recognition and matching principles are followed. It is required every time financial
statements are prepared.
For illustration purpose, we will classify adjusting entries in to the following categories.

 Apportionment of recorded costs

 Apportionment of recorded revenues
 Valuation of assets
 Accrual of unrecorded costs
 accrual of unrecorded revenues

i. Apportionment of recorded costs

It is appropriate for costs that will benefit more than one accounting period. These costs must
be apportioned between periods in a manner that approximates the usefulness derived from

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goods and services in the realization of revenue. Recording periodic depreciation is an
example.

All types of prepayments (prepaid expenses) fall under this category.

They expire either with the passage of time (e.g. rent and insurance) or through use and
consumption (e.g. supplies)
Prepaid expenses can be recorded initially as either an asset or an expense. The expiration of
these costs does not require daily recurring entries, which would be unnecessary and
impractical. It is customary to postpone the recognition of such cost expirations until
financial statements are prepared.
The adjusting entry depends on whether prepaid expenses are recorded initially as an asset or
expenses.

Example: ABC Advertising purchased advertising supplies costing $25,000 on July 5.The
inventory count at December 31, end of the current accounting period, reveals that $10,000 of
supplies are still on hand at the end of the current accounting period

ii. Apportionment of recorded revenue

Revenues received in cash may be either recorded initially as liability or as a revenue.

Example: ABC Advertising received $12,000 on September 1 for advertising services

expected to be completed by March 31.
Prepare adjusting entry as of December 31 end of the current accounting period.

iii. Accrual of unrecorded costs

These are costs accrued but not yet paid.

E.g. interest, rent, taxes, and salaries, etc.

Adjustments for accrued expenses are necessary to record the obligations that exist at the
balance sheet date and to recognize the expenses that apply to the current accounting period.

Example: ABC Advertising signed a 6 month note payable in the amount of $50,000 on
October 1. The note requires at an annual rate of 12%. Prepare adjusting entry as of
December 31, end of the accounting period.

iv. Accrual of unrecorded revenues

Revenues earned but not yet received in cash or recorded at the statement date. An adjusting
entry is required to show the receivable that exists at the balance sheet date and to record the
revenue that has been earned during the period. An asset- revenue relation ship exists.

Example: ABC Advertising earned $2000 in fees for advertising services that were not
billed to clients before December 31, end of the accounting period.

v. Valuation of assets
Sales on account obviously result in some accounts receivable that are uncollectible. So the
estimated expense arising from sale on credit should be recorded in the accounting period in
which sales occur.

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Closing entries:
a. Merchandising enterprises
1. Closing revenue & expense accounts.
Revenue…….XX
Income summary….XX

Income summary….XX
Salaries expense……..XX
Interest expense……..XX
….
….
Advertising expense….XX

2. Closing inventories and related ledger accounts

Inventory (Ending) ………. xx

Purchases ret & allowance…xx
Purchase discounts……….. xx
Income summary …………. xx
Inventory (beginning)…………xx
Purchases………………………xx
Freight………………………….xx
If s separate cost of goods sold ledger account is maintained:
Inventory (Ending) ………. xx
Purchases ret & allowance…xx
Purchase discounts……….. xx
Cost of goods sold ……….. xx
Inventory (beginning)…………xx
Purchases………………………xx
Freight………………………….xx
b. Manufacturing enterprises
The closing procedure is carried out in steps.
A new account is created each time accounts are closed.
Step 1:
Raw martial - ending ….. xx
WIP-ending ……………. xx
Purchases ret & allowances. xx
Cost of finished goods produced.. xx

Raw martial - beginning ….. xx

WIP-beginning……………. xx
Raw material purchases. xx
Freight in xx
Direct labour cost………………. xx
Manufacturing overhead costs …. xx
The new account called "cost of finished goods produced" is created in the process

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Step 2:
Finished goods-end …..xx
Cost of goods sold ……xx
Finished goods -beg………………xx
Cost of finished goods produced….xx
The new account called "cost of goods sold" is created in the process
Step 3:
Sales ………………..xx
Cost of goods sold ………..xx
Sales ret & allowance ……. xx
Salaries expenses …………..xx
Depreciation expense ……...xx
Income summary …………..xx
The new account called "Income summary" is created in the process
Step 4:
Income summary ………xx
Retained earnings ……….xx

Step 5:
Retained earnings ….. xx
Dividend ………………xx

REVERSING ENTRIES
The purpose of reversing entry is to simplify the recording of transactions in the next
accounting period. It does not change the amounts in the financial statements. If reversing
entries are used, the following adjusting entries need to be reversed:
 Adjusting entries for accrued expenses, accrued revenues
 Prepaid expenses and unearned revenues, if initially recorded based on income
statement approach.
Example: Presented below is information related to ABC Co. for the current year ending on
December 31.
1. The unexpired insurance account shows a debit of $5,280, representing the
cost of a 2-year fire insurance policy dated August 1 of the current year.
2. On November 1, rental income was credited for $1,800, representing from rent
for a 3-month period beginning on that date.
3. Purchase of advertising materials for $800 during the year was recorded in the
advertising expense account. On December 31, inventory on hand are $290.
4. Interest of $770 has accrued on notes payable.
Required: a. prepare adjusting for each item
b. the reversing entry for each item, where appropriate.

CORRECTING ENTRIES

Correcting journal entries are those journal entries that are made to correct errors committed.
They are not considered adjusting entries because their function is to correct errors of
omission or commission .For example, the failure to record transaction would be reflected by
a journal entry as it should have been made originally; the improper recording of a
transaction requires a journal entry to ensure that ledger accounts are stated properly. When
an error is made in one accounting period but discovered in a subsequent period, the effect
of the error on the net income of the earlier periods is closed to the retained Earnings

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(owners’ equity) ledger account. When an error is discovered in the period in which the error
occurs, but before the accounting records are closed, revenue and expense accounts may
require correction and the Retained Earnings (owners’ equity) account is not affected.

For example, assume that the following three errors were made in Year1 and were discovered
at the end of the accounting period when the work sheet for the year ended December 31,
Year1, was being prepared
1. A purchase of merchandise for $500 cash was erroneously recorded by a debit of $50
to the supplies expense ledger account and a credit of $50 to cash
2. An acquisition of equipment for cash of $4,000 on April1, Year1 was recorded as a
purchase of merchandise .The equipment had an economic life of 10 years with no
residual value, and was depreciated by the straight line method for nine months in
year1.
3. Collection of $300 from Ato Solomon from sale on account has been credited to the
account of Ato Yohannes.
An analysis of the two errors to determine the appropriate correcting entries follows:
Incorrect journal Correct journal entry that Required correcting entry
Entry as recorder should have been made
1. Supplies expense ----50 purchase ----------500 purchases ----------500
Cash-----------------50 Cash ---------- 500 supplies Expense----- 50
cash………………. 450
2. Purchases ------------300 Equipment ---- 4000 Equipment--------4000
Cash ---------------------- 4000 Depr- Expense--- 300* Depr. expense -----300
Cash------------ 4000 Purchases--------- 4000
Accum.Depr. Accm. Depr.
Of equipment ---- 300 Of equipment……… 300

3.Cash ------------------300 Cash ------------- 300 A/R Yohannes -----------300

A/R Yohannes ----------- 300 A/R Yohannes …… 300 A/R Solomon------------ 300
* 4,000x0.10x3/4 =300