CHAPTER-TWO

ACCOUNTING CYCLE
Introduction
2.1. Accounting cycle: the sequence of accounting principles and procedures employed to process

transactions during the fiscal period. This sequence of procedures is frequently occurs. The most
significant output of the accounting cycle is financial statements.
Nature of Account
An account is an individual accounting record of increases and decreases in a specific asset, liability,
or owner’s equity item. A company will have separate accounts for such items as cash, salaries
expense, accounts payable, and so on.

2.2 Classifications of Accounts

Accounts are classified into five: Assets, liabilities, capital, revenues and, expenses. The first three

accounts are called balance sheet accounts and the other two are called income Statement accounts.

Balance Sheet accounts are those reported on the balance sheet at the end of the reporting period and

Income Statement accounts are reported on the Income Statement.

The five groups of account are discussed below

1. Assets
Resources owned by a business or individual are called assets. Assets could be tangible or
intangible. Tangible assets are assets having physical existence, like cash, land, computer, stationery
materials. Intangible assets do not have physical existence. Example: Goodwill, Copyright, patent
right. Assets are commonly divided into classes and that two of these classes are current assets and

property, plant, and equipment.

A. Current Assets/short term asset

Cash and other assets that are expected to be converted into cash, sold, or used up usually in less than

a year are current assets. Cash: in all forms (coins, currency, checking accounts,…) Notes

Receivable: a written promissory note that the customer will pay a fixed amount by a certain date.

Accounts Receivable: an oral promise for future cash receipt as a result of sales. Merchandise

Inventory: goods held for sale. Prepaid Expenses: expenses paid in advance.
B. Property, plant, and equipment/fixed/permanent/long term asset
Assets that have a life over a year. Physical resources that are owned and used by a business and are
permanent or have a long life. Land: recorded at cost of land. Buildings: record at cost, subject to
depreciation. Equipment and furniture: record at cost, subject to depreciation. Patent right, copy

right and goodwill: record at cost, subject to amortization.

 2. Liabilities
Liabilities are debts owed to outsiders (creditors). Liabilities are often identified on the balance sheet
by titles that include the word payable.
A. Current liabilities.

Liabilities due usually within one year or less and that are to be paid out of current assets are called
current liabilities. Note Payable: a written promissory note that the business promises to pay.

Account payable: an oral promise to pay, arising from credit purchases of inventory and other goods.

Accrued liabilities: liabilities that have occurred but have not been paid. For example: salary

payable, interest payable, etc.

B. Long term liability/Debts

Liabilities due usually more than one year that are to be paid at maturity.

3. Owner’s equity
Owner’s equity is the owner’s right to the assets of the business after all liabilities have been paid.
For a proprietorship, the owner’s equity is represented by the balance of the owner’s capital account.
Income Statement Accounts
Revenues are increases in owner’s equity as a result of selling services or products to customers.

Examples of revenues include fees earned, fares earned, commissions revenue, and rent revenue.

Expenses are the using up of assets or consuming services in the process of generating revenues.

Examples of typical expenses include wages expense, rent expense, utilities expense, supplies

expense, and miscellaneous expense.

Most companies have a chart of accounts that lists the accounts
and the account numbers which identify their location in the
ledger.
Tirat Laundry Service
Assets Owner’s Equity
11 Cash 31 Yichalal, Capital
13 Accounts Receivable 32 Yichalal, Drawing
14 Supplies 33 Income Summary
15 Prepaid Insurance Revenues
16 Office Equipment 41 Fees Earned
19 Accumulated Depreciation — Office Equipment Expenses
Liabilities 51 Rent Expense
21 Notes Payable 52 Insurance Expense
22 Accounts Payable 53 Salaries Expense
23 Unearned Revenue 54 Supplies Expense
24 Salaries Payable 55 Utilities Expense
56 Depreciation Expense
59 Miscellaneous Expense
 What Are Debits and Credits?
 Increases to the T-account are recorded on one side of the T-account, and decreases are
recorded on the other side.
 Tools used for recording transactions
– Debit (Dr)
– Credit(Cr)
 Debit refers to the LEFT and Credit to the RIGHT side of an account.
Debit and Credit are neutral terms and DO NOT connote value judgments. Neither is “good” or
“bad”!
The Journal and journalizing
 Book of original entry.
 Transactions recorded in chronological order.
 Contributions to the recording process:
1. Discloses the complete effects of a transaction.
2. Provides a chronological record of transactions.
3. Helps to prevent or locate errors because the debit and credit amounts can be easily
compared.
Journalizing - Entering transaction data in the journal.

Illustration:- On Nov1 of the current year, NetSolutions’ established a sole proprietorship under the
name of NetSolutions’.
1. Nov. 1, 2009 Chris Clark deposits $25,000 in a bank account in the name of Net Solutions.
2. Nov. 5, 2009 Net Solutions paid $20,000 for the purchase of land as a future building site.
3. Nov. 10, 2009 Net Solutions purchased supplies for $1,350 and agreed to pay the supplier in the
near future.
4. Nov. 18, 2009 Net Solutions received cash of $7,500 for providing services to customers.
5. Nov. 30, 2009 Net Solutions paid the following expenses during the month: wages, $2,125; rent,
$800; utilities, $450; and miscellaneous, $275.
6. Nov. 30, 2009 Net Solutions paid creditors on account, $950.
7. Nov. 30, 2009 Chris Clark determined that the cost of supplies on hand at the end of the month was
$550.
8. Nov. 30, 2009 Chris Clark withdrew $2,000 from Net Solutions for personal use.
Posting Transferring information from a journal to a ledger.
 All transactions are recorded in the journal, then amounts are copied to the ledger accounts
named on the journal line.
 Once the amounts are entered into the accounts, a posting reference (PR) must be entered in
the journal.
 New balances are computed in the running ledger accounts.
 General Ledger Account
T-Account Format

WORK SHEET
 A work sheet is a multiple-column form that may be used in the adjustment process and in
preparing financial statements.
 It is a working tool for the accountant and not a permanent accounting record.
 Use of a work sheet should make the preparation of adjusting entries and financial statements
easier.
 The use of a work sheet is optional.
 When one is used, financial statements are prepared from the worksheet.
 Adjustments are journalized and posted from the work sheet after financial statements are
prepared.
Steps in closing:
• Closing revenue accounts - Debit each revenue account by its balance and credit the ‘Income
Summary’ account by the total revenue for the period.
• Note: Income summary is an account used to close revenue and expense accounts. This
account will immediately be closed to the capital account at the end of the closing process.
– Closing expense accounts – Debit the income summary account by the total of
expenses for the period and credit each expense account by its balance.
– Closing the income summary account – Income summary will be closed to the capital
account. The balance of his account depends on the nature of operation; credit if
result is profit and debit if result is loss.
– Closing Withdrawal – Debit the owner’s equity account by the total of drawings for
the period and credit the drawing account. The temporary accounts of Netsolution
transport are closed as follows:

Service income---------------7,500
2009 Income summary………….…...7,500
nov. 31 Closing revenue
Income summary----------4,450
31 Wage expense……………………..…..…2,125
Rent expense……………………………….800
Utilities expense………………….………..450
Miscellaneous expense……………..….….275
Supplies expense………………………….800
Closing expenses
2009 Income summary………………3,050
nov. 31 Clark, Capital…………………….……....3,050
Closing income summary
31 Clark, Capital…………………...2,000
Clark, Drawing…………………….…......2,000
Closing drawing