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Capturing Economic Events
CHAPTER 2
THE ACCOUNTING
CYCLE
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Steps Involved in the Accounting Cycle
1. Obtain & analyze business transactions by
examining the source documents.( through the
accounting period)
2. Journalize transactions in the journal.
(through the accounting period)
3. Post journal entries to the accounts in the
ledger.( throughout the accounting period)
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 Accounting cycle is a series of steps performed
during the accounting period ( some
throughout the period & some at the end ) to
analyze ,record, classify, summarize,& report
useful financial information for the purpose of
preparing financial statement.
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4. Prepare an unadjusted trial balance.( period end only)
5. Record adjusting entries. .( period end only)
6. Post the adjusting entries. ( period end only)
7.Prepare an adjusted trial balance. ( period end only)
7.Prepare financial statements. ( period end only)
8. Close the temporary accounts. ( period end only)
9. Post the closing entries.( period end only)
10.Prepare a post closing trial balance .( period end only)
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 Account is a part of the accounting system used To illustrate recording the increases & decreases
to classify & summarize the increase, decrease,& in an account, we shall use the T-account, which
balances of each asset, liability, stockholders’ looks like a capital letter T.
equity item, dividend, revenue,& expense.  This simplest form an account consists of
 Companies set up accounts for each different 1 the title of the account
business element such as cash, A/R, & A/P. 2 a left or debit side
 The number of accounts in a companies 3 a right or credit side
accounting system depends on the information Title of Account
needs of those interested in business.
Left or debit side Right or credit
 The main requirement is that each account side
provides information useful in making decisions. Debit balance Credit balance

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Double Entry System

Debits and Credits
 Debit indicates left and Credit indicates right
 Recording $ on the left side of an account is
debiting the account
 Recording $ on the right side is crediting the
account
 If the total of debit amounts is bigger than credits,
the account has a debit balance
 If the total of credit amounts is bigger than debits,
the account has a credit balance
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 The accounting requirement that each transaction be
recorded by an entry that has equal debits & credits is called
double-procedure; or duality.
 This double–entry procedure keeps the accounting equation
in balance.
 The dual recording process produces two sets of accounts-
those with debits balances & those credit balances.
 The totals of theses two groups of accounts must be equal.
 Then, some assurance exists that arithmetic part of the
transaction recording process has been properly carried out.
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Recording Changes in Assets, Liabilities &
Stockholders’ Equity
Assets increase by debits ( left side) to the T-
account & decrease by credits ( right side) the T-
account.
Liabilities & stockholders’ equity decrease by
debits ( left side ) to the T- account & increases by
credits (right side) to the T-account.
 Applying these two rules keeps the accounting
equation in balance.
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Recording Changes in Revenues & Expenses
The recording rules for revenues & expenses are:
 Record increases in revenues on the right (credit)
side of the T- account & decreases on the left ( debit)
side. The reason behind this rule is that revenues
increase retained earnings, & increases in retained
earnings are recorded on the right side.
 Record increases in expenses on the left (side) of the
T-account & decreases on the right (credit) side. The
reasoning behind this rule is that expenses decrease
retained earnings, & decreases in retained earnings
are recorded on the left side.
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Recording Changes in Dividends Normal Balances

 Since dividend decrease retained earnings, Types of Accounts Normal Balances
increases appear on the left side of the dividend Dr. Cr.
account & decreases on the right side.  Assets xx -
Determining the Balance of an Account  Liabilities - xx
 To determine the balance of any T-account, total the  Shareholders’ Equity
debits to the account, total the credits to the account Capital Stock - xx
& subtract the smaller sum from the larger.
Retained Earning - xx
 If the sum of the debits exceeds the sum of the
credits, the account has a debit balance. Dividends xx -
 If,
on other hand, the sum of the credits exceeds the Expenses xx -
sum of the debits, the account has a credit balance. Revenues - xx

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Journal: is a chronological (arrangement in

Debits Credits order of time ) record of business transactions.
1. Increase assets. 1. Decrease assets  A journal entry is the recording of a business
2. Decrease liabilities. 2. Increase liabilities transaction in the journal.
3. Decrease stockholders’ 3. Increase stockholders’  A journal entry shows all the effects of a
equity. equity business transaction as expressed in debit (s) &
4. Decrease revenues. 4. Increase revenues credit (s) & may include an explanation of the
5. Increase expenses. 5. Decrease expenses transaction.
6. Increase dividends. 6. Decrease dividends.
 A transaction is entered in a journal before it is
entered in ledger accounts.( that is why a journal
is being called as a book of original entry)

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 General Journal: contains all types of entry
such as cash payments & receipts, receivable,
sales, purchase, etc.
 General Journal contains the following
information:
1. Date column-year, month,& day.
2. Account titles & explanation column: shows
accounts debited & credited & necessary
explanations.
3. Posting reference column: shows the
account number of debited & credited.
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4. Debit column: show the amount of debit.
5. Credit column: show the amount of credit
Functions & Advantages of Using Journal
 Record transactions in chronological order.
 Shows the analysis of each transaction in
debits & credits.
 Supplies an explanation of each transaction
when necessary.
 Serves as a source for future reference to
accounting transactions.
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 Eliminates the need for lengthy explanations
from the accounts.
 Makes possible posting to the ledger at
convenient times.
 Assists in maintaining the ledger in balance b/c
the debit(s) must always equal in the credit(s)
in each journal entry.
 Aids in tracing errors when the ledger is not in
balance.
The Ledger: or general ledger is the complete
collection of all the accounts of a company .
 Accounts fall in to two general groups:
1. Balance sheet ( assets, liabilities,&
shareholders equity ) accounts.
2. Income statement ( revenues & expenses)
accounts.
 Balance sheet accounts are real accounts
because they are not sub classifications or
subdivisions of any other account.

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 They are permanent accounts because their Chart of Accounts: is the complete listing of the
balances are not transferred (closed) to any titles & numbers of all the accounts in the ledger.
other account at the end of the accounting  The groups of accounts usually appear in the
period. order of assets, liabilities, SHE, dividends,
 Income statement & dividend accounts are revenues, & expenses.
nominal accounts because they are merely sub-  Assets = 100-199
classifications of the SHE accounts.  Liabilities =200-299
 Nominal (temporary) accounts temporarily  SHE =300-399
contain revenue, expense,& dividend  Revenues =400-499
information i.e., transferred (closed) to the RE
 Expenses =500-599
account at the end of the accounting period.
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The Accounting Process in Operation
 The Recording of Transactions & Their
Effects on the Accounts
 Posting is the process of updating the ledger
accounts for the effects of the transactions
recorded in the journal.
 Posting involves copying into the ledger
accounts information that already has been
recorded in the journal.
 Example: post the journal entries to the ledger
for Rapid Pick Up & Delivery Inc
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 With in the asset category, the most liquid (
closest to becoming cash) asset appears first &
the least liquid appears last.
 With in the liabilities, those liabilities with the
shortest maturities appear first.
 Note the listing of the account numbers &
account titles on the left, the column for Dr.
balances, the column for Cr. Balances, & the
equality of the two totals.
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The Trial Balance
 Periodically accountants use a trial balance to
test the equality of their debits & credits.
 A trial balance is the listing of the ledger
accounts & their debit or credit balances to
determine that debits equal credits in the
recording process.
 The accounts appear in the order of assets,
liabilities, SHE, dividends, revenues &
expenses.
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 When the TB doesn’t balance, try retotaling the
two columns.
 If this step doesn’t locate the error, divide the
difference in the totals by 2 & then by 9.
 If the difference is divisible by 2, you may have
transferred a debit balance account to the TB as
a credit, or a credit balance account as a debit.
 When the difference is divisible by 2, look for an
amount in the TB that is equal to one half of the
difference.
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E.g. If the difference is $400,look for an amount
with a balance of $200 & see if it is in the wrong
column.
 If the difference is divisible by 9, you may have
made a transposition error in transferring a
balance to the TB or a slide error.
 A transposition error occurs when two digits are
reversed in the amount ( e.g. 435 as 345 or 110
as 101).
 A slide error occurs when you place a decimal
point incorrectly (e.g., 1,300 recorded as 13.00).
 Thus, when a difference is divisible by 9,
compare the TB amounts with the general
ledger account balances to see if you made a
transposition or slide error in transferring the
amounts.

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 If you still can’t find the error, it may be due to  The equality of the two totals in the TB doesn’t
the following causes: necessarily mean that the accounting process
1. Failing to post part of a journal entry. has been error-free.
2. Posting a Dr. as a Cr. ,or vice versa.  Serious errors may have been made, such as
failure to record a transaction, or posting a Dr.
3. Incorrectly determining the balance of an
or Cr. To the wrong account.
account.
 For e.g., if a transaction involving cash receipt
4. Recording the balance of an account
of $150 is never recorded, the TB total still
incorrectly in the TB.
balance, but an amount that is $ 150 too high.
5. Omitting an account from the TB.
 Both Cash & Revenue would be understated by
6. Making a transposition or slide error in the $150.
account or the journal.
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Basis of Accounting
 The following are the basic systems of recording
business transactions
1. Cash Basis Accounting: According to this basis, only
actual cash receipts & payments are recorded in the
books.
 The credit transactions are not recorded at all, till
actual cash is received or paid.
 Thus, if purchases are made in the year 2010 on credit
& payment for purchases is made in the year 2011,
such purchases shall be considered to be an expense
of the year 2011 & shall not be recorded in the year
2010.
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2. Accrual Basis: According to this basis, all the
business transactions pertaining to the specific
period, whether of cash or credit nature, are
recorded in the books.
 This basis of accounting is based on accrual
concept, which states that revenue is
recognized when it is earned & expense is
recognized when obligation of payment arises.
 Revenues are recognized when sales are made
or services are performed, regardless of when
cash is received.
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 This basis of accounting is mostly followed by
non-trading organizations, professionals like
lawyers, doctors, chartered accountants, etc.
 Because the cash basis of accounting doesn’t
match expenses incurred & revenues earned, it
is generally unacceptable.
 Companies using the cash basis do not have to
prepare any adjusting entries unless they
discover they have made a mistake in preparing
an entry during the accounting period.
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 Expenses are recognized as incurred, whether
or not cash has been paid out.
 Actual movement of cash is irrelevant.
 Accrual basis of accounting is widely followed
by the industrial and commercial undertakings
because it takes into account the effects of all
transactions already entered into.
 Under accrual basis, adjusting entries are
needed to bring the account up to date for
unrecorded economic activity that has taken
place.
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Summary ADJUSTMENTS
Cash Basis Accrual Basis  Adjusting entries are accounting journal
entries that convert a company's accounting
Revenue is As cash is As earned records to the accrual basis of accounting.
recognized received (goods are  An adjusting journal entry is typically made
delivered or just prior to issuing a company's FSs.
services are
performed)  They are journal entries made at the end of an
accounting period or at any time FSs are to be
Expenses are As cash is paid As incurred to prepared to bring about proper matching of
recognized produce revenues & expenses.
revenues.  Done to bring the books up to date in
anticipation of the preparation of the FSs.
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The Need for Adjusting Entries  More specifically, these entries are required to
 Each adjusting entry has a dual purpose: satisfy the realization & matching principle.
1. To make the income statement report the  Adjusting entries are necessary for three
proper revenue or expense, & situations:
2. To make the balance sheet report the proper A. Deferrals (Prepayments)
asset or liability. B. Accruals, and
 Thus, every adjusting entry affects at least one C. Estimates
income statement account & one balance
sheet account.
 Adjusting entries are required to implement
the accrual accounting model.
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A. Deferrals (Prepayments)
 Deferrals occur when the cash flow precedes
either expense or revenue recognition.
For example
 A co. may buy supplies in one period but use them
in a later period.
 The cash outflow creates an asset (supplies)
which then must be expensed in a future period
as the asset is used up.
 Similarly, a co. may receive cash from the
customer in one period but provide the customer
with a good or service in a future period.
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1. Asset/Expense adjustment
 Prepaid Expenses: are the cost of assets
acquired in one period & expensed in the
future.
 The purchase of machinery, equipment, or
supplies or the payment of rent, advertising,
insurance, etc in advance are examples of
payments that create future benefits & should
be recorded as assets.
 Prepaid expense represents assets recorded
when a cash disbursement creates benefits
beyond the current reporting period.
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 The cash inflows creates a liability (unearned
revenue) that is recognized as revenue in a
future period when it is earned.
 Deferred items consists of two types of
adjusting entries:
1. Asset/Expense Adjustment, and
2. Liability/Revenue Adjustments.
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 The benefits provided by these assets expire in
the future periods & their cost is expensed in the
future periods as related revenues are
recognized.
 “The adjusting entry required for a prepaid
expense is a debit to an expense & a credit to
an asset”.
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ILLUSTRATION Eg.1. On October 4, the company paid $600 for

 Prepaid Insurance: When the co. pays an a 1-year insurance policy. Coverage began on
insurance policy premium in advance, the October 1. Record the entry made on October 4
purchase creates the asset, prepaid insurance. to record the payment & prepare the October
 This advance payment is an asset because the 31 adjusting entry to record the use of the
co. will receive insurance coverage in the future. insurance.
 With the passage of time, however, the asset Oct 4 Prepaid insurance 600
gradually expires. Cash 600
 The portion that has expired becomes an Oct 31 Insurance expense 50
expense. Prepaid insurance 50
(Adjusting entry)
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 Prepaid Rent: Recall that on July 1, the co.  Supplies on Hand: On Oct. 5, the company
paid $2,4000 to its land lord representing one paid $5000 for advertising supplies. An
year’s rent in advance. Prepare journal entry on inventory on Oct. 31 reveals that $1,000 of the
July to record the payment of rent & adjusting supplies remain on hand. Record the entry
entry on July 31 to record the expired portion of made on Oct. 5 to record the purchase &
prepaid rent. prepare the Oct. 31 adjusting entry to record the
July 1 Prepaid rent 24000 use of the supplies.
Cash 24000 Oct.5 Supplies 5000
July 31 Rent expense 2000 Cash 5000
Prepaid Rent 2000 Oct. 31 Supplies expense 4000
Supplies 4000
(Adjusting entry)
(Adjusting entry)
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Depreciation: On Oct. 1, the company
purchased office equipment for $4,800. Record
the purchase & depreciation for the month of
Oct. The equipment has an estimated life of 10
years.
Oct. 1 Office eqpt 4,800
Cash 4,800
Oct.31
Deprn expense ($4,800 ÷ 10 ÷ 12
) 40
Accum. Depr Office Eqpt 40
n provide goods or services in the future.
(Adjusting entry)
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 Example: On Oct. 2, the company received
$1,200 for advertising services expected to be
completed by Dec. 31. Record the receipt of
cash & the adjusting entry needed on Oct.31.
Oct. 2 Cash 1,200
Unearned service revenue 1,200
Oct. 31 Unearned service revenue 400
Service revenue 400
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2. Liability/Revenue Adjustments
Unearned Revenues: are created when the
co. receives cash from a customer in one
period for goods or services that are to be
provided in a future period.
 The cash receipt , an external transaction, is
recorded as a debit to cash & a credit to a
liability.
 This liability reflects the co.’s obligation to
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B. Accruals
 Accruals occur when the cash flow comes
after either expense or revenue recognition.
 Accrued items require two types of adjusting
entries:
1. Asset/revenue adjustments, &
2. Liability/expense adjustments.
 The 1st group asset/revenue adjustment
involves accrued assets & the 2nd group
liability/expense adjustments involves accrued
liabilities.
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1. Asset/revenue adjustments Eg.1: During Oct., the company earned $2,000

 Accrued assets are assets, such as interest
receivable, that have not been recoded by
the end of an accounting period.
 These assets represent rights to receive
future payments that are not due at the
balance sheet date.
 To present an accurate picture of the affairs
of the business on the b/s, firms recognize
these rights at the end of an accounting
period by preparing an adjusting entry to
correct the account balances.
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for advertising services, but did not send the
bills until Oct. 31. Record the adjusting entry
needed on Oct. 31.
Oct. 31 Accounts receivable 2,000
Service revenue 2,000
Eg.2:On Oct. 1, the company loaned$10,000 to
Alpha Enterprise. The Company is charging 6%
interest. Record the loan & the adjusting entry
needed on Oct. 31.
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Oct. 1 Notes Receivable 10,000  At the end of the accounting period, the co. recognizes
these obligations by preparing an adjusting entry
Cash 10,000 including both a liability & an expense.
Oct. 31  Example: On Oct. 1, the company borrowed $10,000
from National Bank. The bank is charging 6% interest.
Interest Receivable (10,000 × 6% × 1/12) 50 Record the loan and the adjusting entry needed on
Interest Revenue 50 Oct. 31.
 Oct. 1 Cash 10,000
(Adjusting entry)
Notes payable 10,000
2. Liability/expense adjustments
 Oct. 31 Interest expense (10,000 × 6% × 1/12) 50
 Accrued liabilities are liabilities, such as Interest payable 50
employee salaries, interest expense,…. not yet (Adjusting entry)
recorded at the end of an accounting period.

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Example 2:As of Oct. 31, the company’s
employees had worked 3 days for which they
had not yet been paid. Salaries amount to $500
per day. Record the adjusting entry needed on
Oct. 31.
Oct. 31 Salaries expense 1,500
Salaries payable 1,500
(Adjusting entry)
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 Example: Assume that on Dec.31, the
unadjusted trial balance of ABC Co. indicates
a balance in the A/R of $5,000. Assume also
that the management of the co. felt that only
$4,500 of this amount would ultimately be
collected.
 An adjusting entry is required to decrease A/R
& increase bad debt expense by $500 as
follows:
Bad Debt Expense 500
Allowance for uncollectible accounts 500
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C. Estimates
 A third classification of adjusting entries is
estimates.
 Accountants must make estimates of future
events to comply with the accrual accounting
system.
 One situation involving an estimate that does
not fit neatly into either the deferral or accrual
classification is called bad debt expense.
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 Note that the A/R account is not reduced directly.
 A contra account, called Allowance for
uncollectible accounts , is credited.
 Only when the account is usually written off as
uncollectible would A/R be reduced.
 At this point $500 is just an estimate.
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Effects of Failing to Prepare Adjusting Entries Reporting Financial Statements

Failure to Recognize Effect on Net Income Effect on B/Sheet
 The purpose of each of the steps in the
processing cycle to this point is to provide
1. Consumption of
benefits of an asset
Overstates net income Overstates assets information-preparation of the financial
Overstates REs
( prepaid expense) statements.
2.Earning of previously Understates net income Overstates liabilities
unearned revenue Understates REs

3.Accrual of assets Understate net income Understates assets

Understates REs

4.Accrual of liabilities Overstates NI Understates liabilities

Overstates REs

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1. Income Statement 2. Statement of Retained Earnings

 The information you need to prepare the
income statement can be obtained from the
income statement column of the work sheet.
 Example: Prepare an income statement for
Best-Friend Hospital, Inc on December 31,
2008.
 The information you need to prepare the statement
of REs can be taken from the statement of REs
columns in the work sheet.
 To prepare this statement, use the beginning REs
account balance, if there is any, add/deduct net
income/loss & subtract the dividends.
 Carry the ending REs balance forward to the
balance sheet
 Example: Prepare the statement of REs for Best-
Friend Hospital, Inc on December 31, 2008.

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3. Balance Sheet 1. Assets

- Current Assets
 The balance sheet shows the balance, at a particular
- Cash, -Marketable securities, -Account
time, of each asset, each liability, & stockholders’
receivables, -Inventories, -Prepaid expenses
equity.
- Etc.
 The balance sheet we presented so far have been
-Fixed Assets
unclassified balance sheets.
-Land,-Buildings, -Production equipment
 Unclassified balance sheet has three major categories
-Vehicles ,-Office furniture, -Etc
such as assets, liabilities, & stockholders’ equity.
2. Liabilities
 A classified balance sheet contains the same 3 - Current Liabilities, -Accounts payable ,- Salaries
categories & subdivides them to provide useful payable,- Wages payable, - Dividends payable
information for interpretation & analysis by users of -Unearned revenues, -Sales tax payable, -Etc
financial statements.

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- The Closing Process

Long Term Liabilities
 The closing process transfers:
-Notes payable
1. The balances in the revenue & expense accounts
-Bonds payable to a clearing account called income summary &
- Mortgage payable then to retained earnings , &
-Etc 2. The balance in the Dividends account to the
4. Stockholders' Equity retained earnings account.
-Retained earnings  The closing process reduces revenue, expense,
-Capital stock & Dividends account balances to zero so they are
ready to receive data for the next accounting
period.

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 Accountants may perform the closing process
monthly or annually.
 The Income Summary account is a clearing
account used only at the end of an accounting
period to summarize revenues & expenses for
the period.
 After transferring all revenue &expense account
balances to Income Summary, the balance in
the IS account represents the net income or net
loss for the period.
 Closing the balance in the IS account to the
REs results in a zero balance in IS.
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 The four steps in the closing process are:
1. Closing the revenue accounts: by IS
2. Closing the expense accounts: by IS
3. Closing the Income Summary account-
transferring the balance of the IS account to
REs account.
4. Closing the Dividends account-transferring
the balances of Dividends account to the REs
account.
 Example: Closing entries for Best-Friend
Hospital, Inc on December 31, 2008.
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1. Closing the revenue account

Service Fee Revenues $ 179,010 3. Closing the Income Summary account
Income Summary 179,010 Retained Earnings 49,617
2. Closing the expense account
Income Summary 49,617
Income Summary 228,627
Interest Expense 225 4. Closing the Dividend account
Salaries Expense 144,825 Retained Earnings 0
Advertising Expense 29,250 Dividends 0
Supplies Expense 2,397
Miscellaneous Expense 3,705
Legal & Accounting Expense 13,750
Utilities Expense 1,800
Deprn Exp.Equipment 12,500
Insurance Expense 1,200
Rent Expense 18,975
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The End
Of Chapter 3

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