SECTION THREE:

• Completion of the Accounting Cycle

Using accounting period concept, accountants must
determine in which period the revenues and expenses of
the business should be reported.

•Based on this Revenues and expenses may be reported

on the income statement by either;

(1) the cash basis of accounting or

(2) the accrual basis of accounting.

 Accrual basis of Vs. Cash basis of Accounting

Accrual basis of Accounting:

 Revenues are reported in the period they are earned, and

 expenses are reported in the period incurred regardless

of the time of cash receipt or payment.
 Revenues Earned- when a service /product are sold to
customers.
 Expenses are incurred when the service of some asset is
used, when the services of some Employees used rather
than when cash is paid.
 Accrual basis of Vs. Cash basis of Accounting cont…
 Cash basis of Accounting:
 Revenues are reported in the period in which cash is
received and
 expenses are reported in the period in which cash is paid.

• N/I (or N/L) is the difference between cash receipts and

cash disbursements in operating activity.
• Small service enterprises, which have few receivables
and payables such as accountants, physician, may use the
cash basis of accounting.
 Nature of the adjusting process

• Financial reporting on annual, quarterly or monthly basis

requires accountants to summarize the operations of business
enterprises for specific time period.
• All the trial balance amounts are not necessarily correct at the
end of a particular period because of adjustment requirements.
• The entries required at the end of an accounting period to
bring the accounts up-to-date and to assure proper matching
of revenues and expenses are called adjusting entries.
 Nature of the adjusting process cont..
 Adjusting entries are required only under accrual basis of
accounting.
 note the following;

1. If all financial events are recognized on a day-to-day

basis, there is no need of adjusting entry.
2. Every adjusting entry affects both a balance sheet
account and an income statement account.
 TYPES OF ADJUSTING ENTRIES:

1. To apportion prepayments (allocate) of Expenses or pre

collection of Revenue (Deferrals)
2. To record Accrued Expenses and Revenue (Accruals)

 Purpose of adjusting Entries

1. To measure all assets and Liabilities correctly

2. To measure net income correctly by matching expired
costs (Expenses) with realized revenue
 TYPES OF ADJUSTING ENTRIES:

Figure 1: the two basic classifications of items that give rise to adjustment entries
 Deferrals: Prepaid expenses and Pre-collected
Revenue
a.Apportionment of rerecorded costs:

• Prepayments (prepaid expenses): This include

adjustment for Supplies, Prepaid Rent, Prepaid
insurance, etc.
• There are two alternative ways of recording the
prepayments initially.
 Pre-payments are initially recorded in asset
account
•adjusting entry reduces asset account and increase
expense account for the amount of asset consumed
or for cost expired during a period.
• Example: 1.
Supplies available on book (Balance in 1850
the account)
Less: Supplies on hand (inventory) (890)
Supplies used (amount of adjustment) 960
 Example: 1.

• adjusting entry- decrease asset account and increase

expense account for the amount of adjustment (supplies
used up):
Supplies Supplies Expense
Mar 1 1,200 960
Mar 20 650
1,850
Mar 31. 960
Bal. 890
 Example: 2.

•prepaid rent expired for March; 2400/3 = 800

Prepaid Rent Rent Expense

Mar 1 2,400 800

800
Bal. 1600
 Example: 2. cont…

• If the preceding adjustments for supplies (960) and

prepaid rent (800) are not recorded, the financial
statements prepared as of March31, will be incorrect
(misleading);
• On I/S supplies expense (by 960) and rent expense (by
800) totally for 1760 will be understated leading an
overstatement in net income for the same amount, 1760.
 Example: 2. cont…
• O/E the overstatement in N/I will result in overstating the
ending O/E (capital) by the same amount, 1760.
• the effect of the omission of this adjusting entry is
reflected on B/S as assets (supplies and prepaid rent) are
overstated for 1,760 in total (supplies by 960 and prepaid
rent by 800).
 Pre-payments are initially recorded in an
Expense account
•adjusting Entry reduce expense account and
increase asset account for the amount of asset not
yet consumed or cost not expired.
• Example 1:
Supplies Expense Supplies
Mar 1 1,200 890

Mar 20 650

1,850
Mar31
.
890
Bal. 960
 Example 1:

• If Hill recorded purchase of supplies in a supplies

expense account at the time of purchase;
• before adjustment supplies Expense Account has a
debit balance of 1850.
•The adjusting entry reduces the supplies expense
account and increase the supplies account for the
unconsumed part of supply.
 Example 2:
• if Hill recorded payment of rent in advance as an
expense (Rent Expense)
• before adjustment Rent Expense account has a debit
balance of 2400.
•the adjusting entry reduce Rent Expense account and
increase the asset pre-paid rent for the amount of pre-
payment not yet expired( the remaining two Months
on March 31).
 Example 2:

• Example 2:
Rent Expense Prepaid Rent
Mar 1 2,400 1,600

1,600
Bal. 800
 b. Apportionment of Recorded Revenue:
When a business enterprise receives payment for
goods and services before goods are delivered or
the services are performed, a liability exists until
performance takes place.
When cash is received, the original transaction
may be recorded by a credit to a liability known
as Unearned Revenue account or to a Revenue
account.
Cash…………………………….xxx
unearned revenue…………xxx
Advance (pre) collection is initially recorded in a
liability account:

• adjusting Entry reduce the liability account and

increase the Revenue account for the earned
portion of revenue during the period.
•The earned portion means part for which the
business side obligation is completed/ goods or
services for which the cash is received in advance
are delivered to the client.
 Example
• Assume that customer paid 500,000 birr for
magazine subscription at the beginning of the year.
• Assuming that only magazines having a price of
425,000birr have been delivered to customers
during the year; and the collection of cash was
initially recorded as a liability
•the following adjusting entry is required at end of
this year:
 Example

Unearned Subscription 425,000

Subscriptions Revenue 425000

Advance (pre) collection is initially recorded in a
revenue account:
•adjusting Entry Reduce the revenue account and
increase the liability account for the Unearned
portion of revenue during the period.
Example:
•Assume the above example, except the initial collection of
cash was recorded in a revenue account.
Subscriptions Revenue 75,000

Unearned Subscription 75,000

Accruals: To record Accrued Expenses and Revenue

a)Accrual of unrecorded Expenses

• Accrued Expenses or accrued liabilities are
expenses that have been incurred but have not
been recorded in the accounts.
• The incurring of certain expenses is related to the
passage of time.
• The expenses generally are not recorded until
payment is made, unless the end of accounting
period comes before the required date of payment.
 Accruals: To record Accrued Expenses and Revenue cont…

•Examples: Interest, salaries, Taxes, etc.

•In order to measure expenses accurately for a

period, an adjusting entry is necessary to record the
accrued expenses and the corresponding liability.
 Example:

•The debits of 575 on March 13 and 27 in a salary expense

account for Hill photographic studio were biweekly
payments on alternate Fridays for the payroll periods ended
on those days. The salaries earned on Monday and
Tuesday March 30 and 31, total 115.
•This amount is additional expense of March 31, therefore
credited to Salaries payable:
salaries Expense……………115
Salaries Payable………..115
 a) Accrual of Unrecorded Revenue

• Revenue that has been realized but not recorded must be

recognized at the end of an accounting period.

• Accrued revenues or accrued assets are revenues that have

been earned but have not been recorded in the accounts.

• Examples include: Fees for services that an attorney has

provided but has not billed to the client at the end of the
period, unbilled commissions by travel agent, accrued
interest on notes receivable, and accrued rent on property
rented to others.
 Example:

•Assume that rent totaling 625 that has been

realized but not collected for the month of adjusting
entry on December 31, is required to measure assets
and Revenue correctly.
Rent Receivable……………..625

Rent Revenue……………..625
 Preparation of Worksheet

• Worksheet is a working paper that accountants can

use to summarize adjusting entries and the
account balances for financial statements.
• A worksheet is an important tool, but is not an
essential part of the accounting system, like
accounts, journal, or ledger;
• Eg. for small companies with few accounts and
adjustments, a worksheet may not be necessary.
 Preparation of Worksheet cont…
• Most of the data required to prepare the
accounting reports (financial statements) is now
gathered.
• The worksheet is a large columnar sheet prepared
to arrange in a convenient form all the accounting
data required to prepare financial statements.
 Preparation of Worksheet cont…
• The worksheet has a heading and a body.
• The heading has three parts:
a) Name of the Organization
b) Name of the form (worksheet)
c) Period of time covered.
 Preparation of Worksheet cont…
• The body contains five main parts each of them
with two main columns. These parts are
1) The trial balance
2) The adjustment
3) The adjusted trial balance
4) The income statement
5) The balance sheet.
 Hill Photographic Studio
Work Sheet
For the Month Ended March 31, 1990
Account Trial Balance Adjustments Adjusted TB I/ S Balance Sheet
Title

Cash 1631 1631 1631

A/R 1775 1775 1775

Supplies 1850 (a) 960 890 890

Prepaid Rent 2400 (b) 800 1600 1600

Equip. 17500 17500 17500

A/P 2000 2000 2000

Capital 20650 20650 20650

Drawing 1500 1500 1500

Sales 5525 5525 5525

Salary Expense 1150 (d)115 1265 1265

Miscel. Expense 369 369 369

28175 28175
 Hill Photographic Studio
Work Sheet
For the Month Ended March 31, 1990
Account Trial Balance Adjustments Adjusted TB I/ S Balance Sheet
Title

Supplies (a)960 960 960

Expense

Rent Expense (b)800 800 800

Depreciation (c)175 175 175

Exp.

Accumulated (c )175 175 175

Depr.

Salaries Payable (d) 115 115 115

2050 2050 28465 28465 3569 5525 24896 22940

Net income 1956 1956

5525 5525 24896 24896

 Financial Statements

• Work sheet is an aid in preparing financial

statement.
-The income statement,
-statement of owner’s equity and
- balance sheet prepared from work sheet.
For Hill Photographic Studio, the financial
statements are presented as follows:
 Hill Photographic Studio
Income Statement
For Month Ended March 31, 1990
Sales 5,525

Operating Expenses:

Salary Expense 1,265

Supplies Expense 960

Rent Expense 800

Depreciation expense 175

Miscellaneous Expense 369

Total Operating 3,569

Expenses
Net Income 1,956
 Hill Photographic Studio
Statement of Owner’s Equity
For Month Ended March 31, 1990

• Ann Hill Capital, March 1, 1990…………. 20,650

• Net Income for the Month…………1956
• Less: Withdrawals………………………1500
• Increase in Owner’s equity………… 456
• Ann Hill Capital, March 31, 1990………………21106
 Hill Photographic Studio
Balance Sheet
March 31, 1990
Assets

Current Assets:

Cash 1,631

Account Receivable 1,775

Supplies 890

Prepaid Rent 1,600

Total Current Assets 5,896

Plant Assets:

Photographic Equipment 17,500

Less: Accumulated 175 17,325

Depreciation
Total Assets 23,221
 Hill Photographic Studio
Balance Sheet
March 31, 1990
Liabilities
Current Liabilities:

Account Payable 2,000

Salaries Payable 115

Total Liabilities 2,115

Owner’s Equity

Ann Hill, Capital 21,106

Total Liabilities and owner’s 23,221

Equity
 Closing Entries

• Nature of the Closing Process

There are two types of accounts:
1. Temporary or nominal accounts
They serve only for a given accounting period and it
includes;
• All income statement accounts and
• Drawing account
• They are closed at the end of the accounting
period
 Closing Entries cont…

2. Permanent or real accounts

• They include all balance sheet accounts including
owner’s capital
• They are not closed but their balances are carried
forward to the next accounting period.
The Revenue, Expense, Drawing (dividend) accounts
is temporary accounts used in classifying and
summarizing changes in the Owner’s Equity
during the accounting period.
 Closing Entries cont…

• To report amounts only for one period temporary

account 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.
 Closing Entries cont…

• It is used only at the end of the accounting period

and is both opened and closed in the closing
process.

Four entries are required in order to close

temporary accounts of a sole proprietor ship at
the end of a period:
 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 1………………………….xxx
• Revenue 2………………………….xxx
• Revenue 3………………………….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 1 ………………………………………..xxx
• Expense 2 …………………………………………xxx
• Expense 3………………………………………….xxx
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.)
• Income summary…………xxx
owner’s capital…………….xxx
If there is loss
Owner’s capital…………xxx
I/summary………………….xxx
 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.
• Owner’s capital…………..xxx
drawing………………………….xxx
• Example- for Hill photographic studio see the
data from previous illustration or worksheet
• To close Revenue:
Sales…………………………5525
Income Summary …………………………….5525
• To close Expenses:
Income Summary………………..3569
Salary Expense …………………………1265
Miscellaneous Expense …………..…369
Supplies Expense ………………........960
Rent Expense …………………………….800
Depreciation Expense………………...175
• To close the Income Summary:
Income Summary……….1956
Ann Hill, Capital……………………..1956
• To close Drawing account
Ann Hill, Capital………………1,500
Ann Hill, Drawing …………………..1,500
 Post-Closing Trial Balance

• The last procedure of the accounting cycle is the

preparation trial balance after all of the
temporary accounts have been closed.
• The purpose is just to make sure that the ledger is
in balance at the beginning the new accounting
period.
• The account titles & amounts should agree
exactly with the accounts & amounts listed on the
balance sheet at the end of the period.
 Hill photographic studio
Post-closing Trial Balance
March 31, 1990
Cash 1,631

Accounts Receivable 1,775

Supplies 890

Prepaid Rent 1,600

Photographic Equipment 17,500

Accumulated Depreciation-Photographic Equipment 175

Accounts payable 2,000

Salaries payable 115

Ann Hill, Capital 21,106

Total 23,396 23,396

 3

•END OF SECTION
THREE