Accounting Cycle

MADAWALAMU UNIVERSITY, SCHOOL OF POST GRADUATE STUDIES, Bale-Robe, December 2014
Chapter Two
Accounting Cycle
2.1. Introduction
The term, accounting cycle, refers to the steps involved in accounting for all of the business
activities during an accounting period. These steps are repeated in each reporting period.
There are ten steps to the accounting cycle. These are: analyzing transactions, journalizing
transactions, Posting, . Step four – prepare unadjusted trial balance. Step five – adjust. Step six –
prepare adjusted trial balance. Seven – prepare financial statements. Step eight – close. Step nine
– Prepare a post-closing trial balance and Step Ten – Reverse.The accounting process that begins
with analyzing and journalizing transactions and ends with summarizing and reporting these
transactions is called the accounting cycle. The most important output of this cycle is the
financial statements.
2.2. Capturing Economic Events
Accounting deals with, among other functions, the recording of voluminous business
transactions and events. A business transaction represents any event, activity, dealing or
happening whose effects can be measured in terms of money and which normally results in the
exchange of money or money’s worth between the business entity and pother party/ies causing
the changes in the financial position of the entity. Investment of capital into the business by the
proprietor, purchase and sale of goods, expenses incurred and revenues earned, discounts
allowed or availed of money borrowed or lent, etc… are examples of transactions.
These business transactions may be of:
a) Cash transactions (e.g. purchase of raw materials on cash basis)

b) Credit transactions (e.g. purchase of raw materials on credit basis)
c) Barter or exchange transactions(e.g. purchase of equipment in exchange with computer)
d) Book or paper transactions(depreciation charged on building or equipment)
e) Any combination of all the above transactions
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Financial and Managerial Acct(MBA612): Lecture Note for CH 2 Compiled by Teferi D.
Types of transactions
There are two types of transactions viz., internal transactions and external transactions. The
transactions which are the outcomes of internal happening such as expiration of costs or accrual
adjustments are called internal transactions which are also called accounting transactions. On
the other hand, the external transactions arise on account of company’s relations with outside or
external parties. These external transactions are also called business transactions.
Double – Entry System of Accounting
Double entry accounting is based on the fact that every financial transaction has equal and
opposite effects in at least two different accounts. It is used to satisfy the equation Assets =
Liabilities + Equity, whereby each entry is recorded so as to maintain the relationship.
Every transaction involves a debit entry in one account and a credit entry in another account.
This means that every transaction must be recorded in two accounts; one account will be debited
because it receives value and the other account will be credited because it has given value.
2.3. Debits and Credits
The terms debit and credit mean left and right, respectively. They are commonly abbreviated as
Dr. for debit and Cr. for credit. These terms do not mean increase or decrease. The terms debit
and credit are used repeatedly in the recording process to describe where entries are made. For
example, the act of entering an amount on the left side of an account is called debiting the
account, and making an entry on the right side is crediting the account. When the totals of the
two sides are compared, an account will have a debit balance if the total of the debit amounts
exceeds the credits. An account will have a credit balance if the credit amounts exceed the debits.
The procedure of having debits on the left and credits on the right is an accounting custom or
rule.. This rule applies to all accounts. The equality of debits and credits provides the basis for
the double-entry system of recording transactions (sometimes referred to as double-entry
bookkeeping). Under the universally used double-entry accounting system, the dual (two-sided)
effect of each transaction is recorded in appropriate accounts. This system provides a logical
method for recording transactions. It also offers a means of proving the accuracy of the recorded
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amounts. If every transaction is recorded with equal debits and credits, then the sum of all the
debits to the accounts must equal the sum of all the credits.
Assets + Expenses = Liabilities + Shareholder Equities + Revenues
All asset and expense accounts are increased on the left (or debit side) and decreased on
the right (or credit side).
Conversely, all liability and revenue accounts are increased on the right (or credit side)
and decreased on the left (or debit side), and
Stockholders’ equity accounts, such as Common Stock and Retained Earnings, are
increased on the credit side, whereas Dividends is increased on the debit side.
2.4. Accounting Model or Equation
The accounting equation is the foundation of double entry accounting. The accounting equation
displays that all assets are either financed by borrowing money or paying with the money of the
company's shareholders. Thus, the accounting equation is:
Assets = Liabilities + Shareholder Equity
The balance sheet is a complex display of this equation, showing that the total assets of a
company are equal to the total of liabilities and shareholder equity. Any purchase or sale by an
accounting equity has an equal effect on both sides of the equation, or offsetting effects on the
same side of the equation.
2.5. Recording of Business Transactions – Methods and Steps
Step 1: Identifying and Recording Transactions and Other Events
The first step in the accounting cycle is analysis of transactions and selected other events. The
problem is to determine what to record. No simple rules exist that state whether an event should
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be recorded. Most agree that changes in personnel, changes in managerial policies, and the value
of human resources, though important, should not be recorded in the accounts. On the other
hand, when the company makes a cash sale or purchase—no matter how small—it should be
recorded. The phrase ―transactions and other events and circumstances that affect a business
enterprise‖ is used to describe the sources or causes of changes in an entity’s assets, liabilities,
and equity.1 Events are of two types: (1) External events involve interaction between an entity
and its environment, such as a transaction with another entity, a change in the price of a good or
service that an entity buys or sells, a flood or earthquake, or an improvement in technology by a
competitor. (2) Internal events occur within an entity, such as using buildings and machinery in
operations or transferring or consuming raw materials in production processes.
Many events have both external and internal elements. For example, acquiring the services of
employees or others involves exchange transactions, which are external events. Using those
services (labor), often simultaneously with their acquisition, is part of production, which is
internal. Events may be initiated and controlled by an entity, such as the purchase of
merchandise or the use of a machine. Or they may be beyond its control, such as an interest rate
change, a theft or vandalism, or the imposition of taxes.
Transactions, as particular kinds of external events, may be an exchange in which each entity
both receives and sacrifices value, such as purchases and sales of goods or services. Or
transactions may be transfers in one direction in which an entity incurs a liability or transfers an
asset to another entity without directly receiving (or giving) value in exchange. Examples include
investments by owners, distributions to owners, payment of taxes, gifts, charitable contributions,
casualty losses, and thefts. In short, as many events as possible that affect the financial position
of the enterprise are recorded. Some events are omitted because of tradition and others because
the problems of measuring them are too complex. The accounting profession in recent years has
shown signs of breaking with age-old traditions and is more receptive than ever to accepting the
challenge of measuring and reporting events and phenomena previously viewed as too complex
and immeasurable.
Deciding what to recognize in the accounts is governed by the concepts accepted in accounting.
An item should be recognized in the financial statements if it is an element, is measurable, and is
relevant and reliable. Should we value employees for balance sheet and income statement
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purposes? Certainly skilled employees are an important asset (highly relevant), but the problems
of determining their value and measuring it reliably have not yet been solved. Consequently,
human resources are not recorded. Perhaps when measurement techniques become more
sophisticated and accepted such information will be presented, if only in supplemental form.
Step 2: Journalizing
Differing effects on the basic business elements (assets, liabilities, and equities) are categorized
and collected in accounts. The general ledger is a collection of all the asset, liability,
stockholders’ equity, revenue, and expense accounts. A T-account (as shown in Illustration 3-8,
on page 71) is a convenient method of illustrating the effect of transactions on particular asset,
liability, equity, revenue, and expense items.
In practice, transactions and selected 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. To circumvent this deficiency and to have a complete record of each transaction or other
event in one place, a journal (also called ―the book of original entry‖) is employed. The simplest
journal form is a chronological listing of transactions and other events expressed in terms of
debits and credits to particular accounts.
This is called a general journal. 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. Debits are entered first, followed by the credits, which are slightly
indented. The explanation is begun below the name of the last account to be credited and may
take one or more lines. The ―Ref.‖ column is completed at the time the accounts are posted. In
some cases, businesses use special journals in addition to the general journal. Special journals
summarize transactions possessing a common characteristic (e.g., cash receipts, sales, purchases,
cash payments), thereby reducing the time necessary to accomplish the various bookkeeping
tasks.
Step 3: Posting
The items entered in a general journal must be transferred to the general ledger. This procedure,
posting, is part of the summarizing and classifying process.
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Step 4: Preparing Trial Balance
A trial balance is a list of accounts and their balances at a given time. Customarily, a trial balance
is prepared at the end of an accounting period. The accounts are listed in the order in which they
appear in the ledger, with debit balances listed in the left column and credit balances in the right
column. The totals of the two columns must be in agreement. The primary purpose of a trial
balance is to prove the mathematical equality of debits and credits after posting. Under the
double-entry system this equality will occur when the sum of the debit account balances equals
the sum of the credit account balances. A trial balance also uncovers errors in journalizing and
posting. In addition, it is useful in the preparation of financial statements. The procedures for
preparing a trial balance consist of:
Listing the account titles and their balances.
Totaling the debit and credit columns.
Proving the equality of the two columns.
A trial balance does not prove that all transactions have been recorded or that the ledger is
correct. Numerous errors may exist even though the trial balance columns agree. For example,
the trial balance may balance even when (1) a transaction is not journalized, (2) a correct journal
entry is not posted, (3) a journal entry is posted twice, (4) incorrect accounts are used in
journalizing or posting, or (5) offsetting errors are made in recording the amount of a transaction.
In other words, as long as equal debits and credits are posted, even to the wrong account or in the
wrong amount, the total debits will equal the total credits.
Step 5: Preparing Adjusting Entries
In order for revenues to be recorded in the period in which they are earned, and for expenses to
be recognized in the period in which they are incurred, adjusting entries are made at the end of
the accounting period. In short, adjustments are needed to ensure that the revenue recognition
and matching principles are followed.
The use of adjusting entries makes it possible to report on the balance sheet the appropriate
assets, liabilities, and owners’ equity at the statement date and to report on the income statement
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the proper net income (or loss) for the period. However, the trial balance—the first pulling
together of the transaction data—may not contain up-to-date and complete data. This is true 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 of such costs 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.
Adjusting entries are required every time when financial statements are prepared. An essential
starting point is an analysis of each account in the trial balance to determine whether it is
complete and up-to-date for financial statement purposes. The analysis requires a thorough
understanding of the company’s operations and the interrelationship of accounts. The preparation
of adjusting entries is often an involved process that requires the services of a skilled
professional. In accumulating the adjustment data, the company may need to make inventory
counts of supplies and repair parts. Also it may be desirable to prepare supporting schedules of
insurance policies, rental agreements, and other contractual commitments. Adjustments are often
prepared after the balance sheet date. However, the entries are dated as of the balance sheet date.
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Types of Adjusting Entries
Adjusting entries can be classified as either Deferrals /prepayments/ or accruals. Each of these
classes has two subcategories as shown below.
Prepayments Accruals
1. Prepaid Expenses. Expenses 3. Accrued Revenues. Revenues

paid in cash and recorded as assets earned but not yet received in cash or
before they are used or consumed. recorded.
1. Unearned Revenues. Revenues 4. Accrued Expenses. Expenses

received in cash and recorded as incurred but not yet paid in cash or
liabilities before they are earned recorded.
Adjusting Entries for Prepayments
As indicated earlier, deferrals or prepayments are either prepaid expenses or unearned revenues.
Adjusting entries for prepayments are required at the statement date to record the portion of the
prepayment that represents the expense incurred or the revenue earned in the current accounting
period. Assuming an adjustment is needed for both types of prepayments, the asset and liability
are overstated and the related expense and revenue are understated. For example, in the trial
balance, the balance in the asset Supplies shows only supplies purchased. This balance is
overstated; the related expense account, Supplies Expense, is understated because the cost of
supplies used has not been recognized. Thus the adjusting entry for prepayments will decrease a
balance sheet account and increase an income statement account.
Prepaid Expenses: Expenses paid in cash and recorded as assets before they are used or
consumed are identified as prepaid expenses. When a cost is incurred, an asset account is debited
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to show the service or benefit that will be received in the future. Prepayments often occur in
regard to insurance, supplies, advertising, and rent. In addition, prepayments are made when
buildings and equipment are purchased. Prepaid expenses expire either with the passage of time
(e.g., rent and insurance) or through use and consumption (e.g., supplies). The expiration of these
costs does not require daily recurring entries, which would be unnecessary and impractical.
Accordingly, it is customary to postpone the recognition of such cost expirations until financial
statements are prepared. At each statement date, adjusting entries are made to record the
expenses that apply to the current accounting period and to show the unexpired costs in the asset
accounts.
Prior to adjustment, assets are overstated and expenses are understated. Thus, the prepaid
expense adjusting entry results in a debit to an expense account and a credit to an asset account.
Supplies: Several different types of supplies are used in a business enterprise. For example, a
CPA firm will have office supplies such as stationery, envelopes, and accounting paper. An
advertising firm will have advertising supplies such as graph paper, video film, and poster paper.
Supplies are generally debited to an asset account when they are acquired. During the course of
operations, supplies are depleted or entirely consumed. However, recognition of supplies used is
deferred until the adjustment process, when a physical inventory (count) of supplies is taken. The
difference between the balance in the Supplies (asset) account and the cost of supplies on hand
represents the supplies used (expense) for the period.
ABC Co. purchased advertising supplies costing $25,000 on October 5. The debit was made to
the asset Advertising Supplies.
This account shows a balance of $25,000 in the October 31 trial balance. An inventory count at
the close of business on October 31 reveals that $10,000 of supplies are still on hand. Thus, the
cost of supplies used is $15,000 ($25,000 – $10,000), and the following adjusting entry is made.
Oct. 31
Advertising Supplies Expense 15,000
Advertising Supplies 15,000
(To record supplies used)
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After the adjusting entry is posted, the two supplies accounts in T-account formshow the
following.
Advertising Supplies Advertising Supplies Expense
25,000 Adj. 15,000 Adj. 15,000
Bal. 10,000
The asset account Advertising Supplies now shows a balance of $10,000, which is equal to the
cost of supplies on hand at the statement date. In addition, Advertising Supplies Expense shows a
balance of $15,000, which equals the cost of supplies used in October. If the adjusting entry is
not made, October expenses will be understated and net income overstated by $15,000.
Moreover, both assets and owners’ equity will be overstated by $15,000 on the October 31
balance sheet.
Insurance: Most companies have fire and theft insurance on merchandise and equipment,
personal liability insurance for accidents suffered by customers, and automobile insurance on
company cars and trucks. The cost of insurance protection is determined by the payment of
insurance premiums. The term and coverage are specified in the insurance policy. The minimum
term is usually one year, but three- to five-year terms are available and offer lower annual
premiums. Insurance premiums normally are charged to the asset account Prepaid Insurance
when paid. At the financial statement date it is necessary to debit Insurance Expense and credit
Prepaid Insurance for the cost that has expired during the period.
On October 4, ABC Co. paid $6,000 for a one-year fire insurance policy. The effective date of
coverage was October 1. The premium was charged to Prepaid Insurance when it was paid, and
this account shows a balance of $6,000 in the October 31 trial balance. An analysis of the policy
reveals that $500 ($6,000/ 12) of insurance expires each month. Thus, the following adjusting
entry is made.
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Oct. 31
Insurance Expense 500
Prepaid Insurance 500
(To record insurance expired)
After the adjusting entry is posted, the accounts show:
Insurance Accounts after
Prepaid Insurance Insurance Expense
6,000 Adj. 500 Adj. 500
Bal. 5,500
The asset Prepaid Insurance shows a balance of $5,500, which represents the unexpired cost
applicable to the remaining 11 months of coverage. At the same time, the balance in Insurance
Expense is equal to the insurance cost that has expired in October.
If this adjustment is not made, October expenses will be understated by $500 and net income
overstated by $500. Moreover, both assets and owners’ equity also will be overstated by $500 on
the October 31 balance sheet.
Depreciation: A business enterprise typically owns a variety of productive facilities such as

buildings, equipment, and motor vehicles. These assets provide a service for a number of years.
The term of service is commonly referred to as the useful life of the asset.
Because an asset such as a building is expected to provide service for many years, it is recorded
as an asset, rather than an expense, in the year it is acquired. Such assets are recorded at cost, as
required by the cost principle.
According to the matching principle, a portion of the cost of a long-lived asset should be
reported as an expense during each period of the asset’s useful life. Depreciation is the process of
allocating the cost of an asset to expense over its useful life in a rational and systematic manner.
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Need for depreciation adjustment. From an accounting standpoint, the acquisition of productive
facilities is viewed essentially as a long-term prepayment for services. The need for making
periodic adjusting entries for depreciation is, therefore, the same as described before for other
prepaid expenses—that is, to recognize the cost that has expired (expense) during the period and
to report the unexpired cost (asset) at the end of the period.
In determining the useful life of a productive facility, the primary causes of depreciation are
actual use, deterioration due to the elements, and obsolescence. At the time an asset is acquired,
the effects of these factors cannot be known with certainty, so they must be estimated. Thus, you
should recognize that depreciation is an estimate rather than a factual measurement of the cost
that has expired. A common procedure in computing depreciation expense is to divide the cost of
the asset by its useful life.
For example, assume that ABC Co., depreciation on the office equipment is estimated to have
cost $50,000, salvage value $2,000 and useful life of 10 years. Using straight line, the
depreciation expense will be $400 (50000-2,000/120months) per month. Accordingly,
depreciation for October is recognized by the following adjusting entry.
Oct. 31
Depreciation Expense 400
Accumulated Depreciation—Office Equipment 400
(To record monthly depreciation)
The balance in the accumulated depreciation account will increase $400 each month. Therefore,
after journalizing and posting the adjusting entry at November 30, the balance will be $800.
Statement presentation: Accumulated Depreciation—Office Equipment is a contra asset

account. A contra asset account is an account that is offset against an asset account on the
balance sheet. This means that the accumulated depreciation account is offset against Office
Equipment on the balance sheet and that its normal balance is a credit. This account is used
instead of crediting Office Equipment in order to permit disclosure of both the original cost of
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the equipment and the total cost that has expired to date. In the balance sheet, Accumulated
Depreciation—Office Equipment is deducted from the related asset account as follows.
The difference between the cost of any depreciable asset and its related accumulated depreciation
is referred to as the book value of that asset book value of the equipment at the balance sheet
date is $49,600. It is important to realize that the book value and the market value of the asset are
generally two different amounts. The reason the two are different is that depreciation is not a
matter of valuation but rather a means of cost allocation.
Note also that depreciation expense identifies that portion of the asset’s cost that has expired in
October. As in the case of other prepaid adjustments, the omission of this adjusting entry would
cause total assets, total owners’ equity, and net income to be overstated and depreciation expense
to be understated. If additional equipment is involved, such as delivery or store equipment, or if
the company has buildings, depreciation expense is recorded on each of these items. Related
accumulated depreciation accounts also are established. These accumulated depreciation
accounts would be described in the ledger as follows: Accumulated Depreciation— Delivery
Equipment; Accumulated Depreciation—Store Equipment; and Accumulated Depreciation—
Buildings.
Unearned Revenues: Revenues received in cash and recorded as liabilities before they are
earned are called unearned revenues. Such items as rent, magazine subscriptions, and customer
deposits for further service may result in unearned revenues.
Airlines receipts cash from the sale of tickets as unearned revenue until the flight service is
provided. Similarly, tuition received prior to the start of a semester is considered to be unearned
revenue. Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on
the books of one company is likely to be a prepayment on the books of the company that has
made the advance payment. For example, if identical accounting periods are assumed, a landlord
will have unearned rent revenue when a tenant has prepaid rent.
When the payment is received for services to be provided in a future accounting period, an
unearned revenue (a liability) account should be credited to recognize the obligation that exists.
Unearned revenues are subsequently earned through rendering service to a customer. During the
accounting period it may not be practical to make daily recurring entries as the revenue is earned.
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In such cases, the recognition of earned revenue is delayed until the adjustment process. Then an
adjusting entry is made to record the revenue that has been earned and to show the liability that
remains. In the typical case, liabilities are overstated and revenues are understated prior to
adjustment. Thus, the adjusting entry for unearned revenues results in a debit (decrease) to a
liability account and a credit (increase) to a revenue account.
ABC Co. received $12,000 on October 2 from XYZ Inc. for advertising services expected to be
completed by December 31. The payment was credited to Unearned Service Revenue, and this
account shows a balance of $12,000 in the October 31 trial balance. When analysis reveals that
$4,000 of these services have been earned in October, the following adjusting entry is made.
Oct. 31
Unearned Service Revenue 4,000
Service Revenue 4,000
(To record revenue for services provided)
The liability Unearned Service Revenue now shows a balance of $8,000, which represents the
remaining advertising services expected to be performed in the future. At the same time, Service
Revenue shows total revenue earned in October of $104,000. If this adjustment is not made,
revenues and net income will be understated by $4,000 in the income statement. Moreover,
liabilities will be overstated and owners’ equity will be understated by $4,000 on the October 31
balance sheet.
Adjusting Entries for Accruals
The second category of adjusting entries is accruals. Adjusting entries for accruals are required
to record revenues earned and expenses incurred in the current accounting period that have not
been recognized through daily entries. If an accrual adjustment is needed, the revenue account
(and the related asset account) and ⁄or the expense account (and the related liability account) is
understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an
income statement account.
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ADJUSTING ENTRIES FOR ACCRUALS
Accrued Revenues: Revenues earned but not yet received in cash or recorded at the statement
date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time,
as in the case of interest revenue and rent revenue. Or they may result from services that have
been performed but neither billed nor collected, as in the case of commissions and fees. The
former are unrecorded because the earning of interest and rent does not involve daily
transactions. The latter may be unrecorded because only a portion of the total service has been
provided. 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. Prior to adjustment both
assets and revenues are understated. Accordingly, an adjusting entry for accrued revenues results
in a debit (increase) to an asset account and a credit (increase) to a revenue account.
ILLUSTRATION
In October Pioneer Advertising Agency earned $2,000 for advertising services that were not
billed to clients before October 31. Because these services have not been billed, they have not
been recorded. Thus, the following adjusting entry is made.
Oct. 31
Accounts Receivable 2,000
Service Revenue 2,000
(To record revenue for services provided)
Accrued Expenses: Expenses incurred but not yet paid or recorded at the statement date are
called accrued expenses. Interest, rent, taxes, and salaries can be accrued expenses. Accrued
expenses result from the same causes as accrued revenues. In fact, an accrued expense on the
books of one company is an accrued revenue to another company. For example, the $2,000
accrual of service revenue by Pioneer is an accrued expense to the client that received the
service.
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. Prior to
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adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for
accrued expenses results in a debit (increase) to an expense account and a credit (increase) to a
liability account.
Illustration
Pioneer Advertising Agency signed a three-month note payable in the amount of $50,000 on
October 1. The note requires interest at an annual rate of 12 percent. The amount of the interest
accumulation is determined by three factors: (1) the face value of the note, (2) the interest rate,
which is always expressed as an annual rate, and (3) the length of time the note is outstanding.
The total interest due on Pioneer’s $50,000 note at its due date three months hence is $1,500
($50,000 12% 3/12), or $500 for one month.
Interest = Face Value of Note x Annual Interest Rate x time
= $50,000 x 12% x 1/12 = $500
Note that the time period is expressed as a fraction of a year. The accrued expense adjusting
entry at October 31 is as follows.
Oct. 31
Interest Expense 500
Interest Payable 500
(To record interest on notes payable)
Interest Expense shows the interest charges applicable to the month of October. The amount of
interest owed at the statement date is shown in Interest Payable. It will not be paid until the note
comes due at the end of three months. The Interest Payable account is used instead of crediting
Notes Payable to disclose the two types of obligations (interest and principal) in the accounts and
statements. If this adjusting entry is not made, liabilities and interest expense will be understated,
and net income and owners’ equity will be overstated.
Accrued Salaries: Some types of expenses, such as employee salaries and commissions, are
paid for after the services have been performed. At Pioneer Advertising, salaries were last paid
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on October 26; the next payment of salaries will not occur until November 9. As shown in the
calendar below, three working days remain in October (October 29–31).
At October 31, the salaries for these days represent an accrued expense and a related liability to
Pioneer Advertising. The employees receive total salaries of $10,000 for a five-day work week,
or $2,000 per day. Thus, accrued salaries at October 31 are $6,000 ($2,000 3), and the adjusting
entry is as follows.
Oct. 31
Salaries Expense 6,000
Salaries Payable 6,000
Bad Debts: Proper matching of revenues and expenses dictates recording bad debts as an
expense of the period in which revenue is earned instead of the period in which the accounts or
notes are written off. The proper valuation of the receivable balance also requires recognition of
uncollectible, worthless receivables. Proper matching and valuation require an adjusting entry.
At the end of each period an estimate is made of the amount of current period revenue on
account that will later prove to be uncollectible. The estimate is based on the amount of bad
debts experienced in past years, general economic conditions, how long the receivables are past
due, and other factors that indicate the element of uncollectibility. Usually it is expressed as a
percentage of the revenue on account for the period.
To illustrate, assume that experience indicates a reasonable estimate for bad debt expense for the
month is $1,600. The adjusting entry for bad debts is:
Oct. 31
Bad Debt Expense 1,600
Allowance for Doubtful Accounts 1,600
(To record monthly bad debt expense)
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Adjusted Trial Balance
After all adjusting entries have been journalized and posted, another trial balance is prepared
from the ledger accounts. This trial balance is called an adjusted trial balance. It shows the
balance of all accounts, including those that have been adjusted, at the end of the accounting
period. The purpose of an adjusted trial balance is to show the effects of all financial events that
have occurred during the accounting period.
Closing Entry
Basic Process
The procedure generally followed to reduce the balance of nominal (temporary) accounts to zero
in order to prepare the accounts for the next period’s transactions is known as the closing
process. In the closing process all of the revenue and expense account balances (income
statement items) are transferred to a clearing or suspense account called Income Summary,
which is used only at the end of each accounting period (yearly). Revenues and expenses are
matched in the Income Summary account. The net result of this matching, which represents the
net income or net loss for the period, is then transferred to an owners’ equity account (retained
earnings for a corporation, and capital accounts normally for proprietorships and partnerships).
All such closing entries are posted to the appropriate general ledger accounts.
For example, assume that revenue accounts of Collegiate Apparel Shop have the following
balances, after adjustments, at the end of the year.
Sales Revenue $280,000
Rental Revenue 27,000
Interest Revenue 5,000
18
These revenue accounts would be closed and the balances transferred by the following closing
journal entry.
Sales Revenue 280,000
Rental Revenue 27,000
Interest Revenue 5,000
Income Summary 312,000
(To close revenue accounts to Income Summary)
Assume that the expense accounts, including Cost of Goods Sold, have the following balances,
after adjustments, at the end of the year.
Cost of Goods Sold $206,000
Selling Expenses 25,000
General and Administrative Expenses 40,600
Interest Expense 4,400
Income Tax Expense 13,000
19
These expense accounts would be closed and the balances transferred through the following
closing journal entry.
Cost of Goods Sold 206,000
Selling Expenses 25,000
General and Administrative Expenses 40,600
Interest Expense 4,400
Income Tax Expense 13,000
(To close expense accounts to Income Summary)
The Income Summary account now has a credit balance of $23,000, which is net income. The
net income is transferred to owners’ equity by closing the Income Summary account to Retained
Earnings as follows.
Retained Earnings 23,000
(To close Income Summary to Retained Earnings)
Assuming that dividends of $7,000 were declared and distributed during the year, the Dividends
account is closed directly to Retained Earnings as follows.
Retained Earnings 7,000
Dividends 7,000
(To close Dividends to Retained Earnings)
20
After the closing process is completed, each income statement (i.e., nominal) account is balanced
out to zero and is ready for use in the next accounting period.
Post-Closing Trial Balance
It is already mentioned that a trial balance is taken after the regular transactions of the period
have been entered and that a second trial balance (the adjusted trial balance) is taken after the
adjusting entries have been posted. A third trial balance may be taken after posting the closing
entries. The trial balance after closing, called the post-closing trial balance, shows that equal
debits and credits have been posted to the Income Summary account. The post-closing trial
balance consists only of asset, liability, and owners’ equity (the real) accounts.
Reversing Entries
After the financial statements have been prepared and the books have been closed, it is often
helpful to reverse some of the adjusting entries before recording the regular transactions of the
next period. Such entries are called reversing entries. A reversing entry is made at the beginning
of the next accounting period and is the exact opposite of the related adjusting entry made in the
previous period. The recording of reversing entries is an optional step in the accounting cycle
that may be performed at the beginning of the next accounting period.
WORK SHEET
To facilitate the end-of-period (monthly, quarterly, or annually) accounting and reporting

process, a work sheet is often used. Such a work sheet can be prepared on columnar paper or
within an electronic spreadsheet. In either form, the work sheet is used to adjust account balances
and to prepare financial statements. The 10-column work sheet in provides columns for the first
trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. Use of a
work sheet helps the accountant prepare the financial statements on a more timely basis. It is not
necessary to delay preparation of the financial statements until the adjusting and closing entries
are journalized and posted.
The work sheet does not replace the financial statements. Instead, it is an informal device for
accumulating and sorting information needed for the financial statements. Completing the work
21
sheet provides considerable assurance that all of the details related to the end-of-period
accounting and statement preparation have been properly brought together.
Basic Terminology
EVENT: A happening of consequence. An event generally is the source or cause of changes in

assets, liabilities, and equity. Events may be external or internal.
TRANSACTION: An external event involving a transfer or exchange between two or more

entities.
ACCOUNT: A systematic arrangement that shows the effect of transactions and other events on
a specific asset or equity. A separate account is kept for each asset, liability, revenue, expense,
and for capital (owners’ equity).
REAL AND NOMINAL ACCOUNTS: Real (permanent) accounts are asset, liability, and
equity accounts; they appear on the balance sheet. Nominal (temporary) accounts are revenue,
expense, and dividend accounts; except for dividends, they appear on the income statement.
Nominal accounts are periodically closed; real accounts are not.
LEDGER: The book (or computer printouts) containing the accounts. Each account usually has
a separate page. A general ledger is a collection of all the asset, liability, owners’ equity,
revenue, and expense accounts. A subsidiary ledger contains the details related to a given
general ledger account.
JOURNAL: The book of original entry where transactions and selected other events are initially
recorded. Various amounts are transferred to the ledger from the book of original entry, the
journal.
POSTING: The process of transferring the essential facts and figures from the book of original
entry to the ledger accounts.
TRIAL BALANCE: A list of all open accounts in the ledger and their balances. Atrial balance
taken immediately after all adjustments have been posted is called an adjusted trial balance. A
trial balance taken immediately after closing entries have been posted is designated as a post-
closing or after-closing trial balance. A trial balance may be prepared at any time.
22
ADJUSTING ENTRIES: are entries made at the end of an accounting period to bring all
accounts up to date on an accrual accounting basis so that correct financial statements can be
prepared.
FINANCIAL STATEMENTS: Statements that reflect the collection, tabulation, and final
summarization of the accounting data. Four statements are involved: (1) The balance sheet
shows the financial condition of the enterprise at the end of a period. (2) The income statement
measures the results of operations during the period. (3) The statement of cash flows reports the
cash provided and used by operating, investing, and financing activities during the period. (4)
The statement of retained earnings reconciles the balance of the retained earnings account
from the beginning to the end of the period.
CLOSING ENTRIES: The formal process by which all nominal accounts are reduced to zero
and the net income or net loss is determined and transferred to an owners’ equity account; also
known as ―closing the ledger,‖ ―closing the books,‖ or merely ―closing
23

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MADAWALAMU UNIVERSITY, SCHOOL OF POST GRADUATE STUDIES, Bale-Robe, December 2014

2.2. Capturing Economic Events

These business transactions may be of:

a) Cash transactions (e.g. purchase of raw materials on cash basis)

Double – Entry System of Accounting

2.3. Debits and Credits

Assets + Expenses = Liabilities + Shareholder Equities + Revenues

Assets = Liabilities + Shareholder Equity

2.5. Recording of Business Transactions – Methods and Steps

Step 1: Identifying and Recording Transactions and Other Events

Step 4: Preparing Trial Balance

Listing the account titles and their balances.

Totaling the debit and credit columns.

Proving the equality of the two columns.

Step 5: Preparing Adjusting Entries

Some events are not journalized daily because it is not expedient.

Some items may be unrecorded.

Types of Adjusting Entries

1. Prepaid Expenses. Expenses 3. Accrued Revenues. Revenues

1. Unearned Revenues. Revenues 4. Accrued Expenses. Expenses

Adjusting Entries for Prepayments

Advertising Supplies Advertising Supplies Expense

25,000 Adj. 15,000 Adj. 15,000

Insurance Accounts after

Prepaid Insurance Insurance Expense

6,000 Adj. 500 Adj. 500

Depreciation: A business enterprise typically owns a variety of productive facilities such as

Depreciation Expense 400

Accumulated Depreciation—Office Equipment 400

(To record monthly depreciation)

Statement presentation: Accumulated Depreciation—Office Equipment is a contra asset

Unearned Service Revenue 4,000

Service Revenue 4,000

(To record revenue for services provided)

Adjusting Entries for Accruals

ADJUSTING ENTRIES FOR ACCRUALS

Accounts Receivable 2,000

Service Revenue 2,000

(To record revenue for services provided)

Interest = Face Value of Note x Annual Interest Rate x time

= $50,000 x 12% x 1/12 = $500

Interest Expense 500

Interest Payable 500

(To record interest on notes payable)

Salaries Expense 6,000

Salaries Payable 6,000

Bad Debt Expense 1,600

Allowance for Doubtful Accounts 1,600

(To record monthly bad debt expense)

Adjusted Trial Balance

Sales Revenue $280,000

Rental Revenue 27,000

Interest Revenue 5,000

Sales Revenue 280,000

Rental Revenue 27,000

Interest Revenue 5,000

Income Summary 312,000

(To close revenue accounts to Income Summary)

Cost of Goods Sold $206,000

Selling Expenses 25,000

General and Administrative Expenses 40,600

Interest Expense 4,400

Income Tax Expense 13,000

Income Summary 289,000