Chapter Two

The Accounting Cycle

The accounting process or cycle is a complete sequence of accounting procedures that are
repeated in the same order during each accounting period.

The activities to be undertaken in the accounting cycle include:

 Analyzing and recording business transactions in a journal
 Posting entries to the accounts in a ledger
 Preparing trial balance
 Adjusting, correcting, and updating recorded data; completion of the work sheet.
 Summarizing adjusted and corrected work sheet data in the form of financial statements.
 Recording and posting closing entries
 Preparing post-closing trial balance.
The recording process begins with the transaction. Business documents, such as a sales slip, a
check, a bill, or a cash register tape, provide evidence of the transaction. Transactions and other
events and circumstances are the sources or causes of changes in an entity’s assets, liabilities,
and equity.

Events are of two types:

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.
Internal events: occur within an entity, such as using buildings and machinery in
operations, or transferring or consuming raw materials in production processes.

Transactions are types of external events. They are an exchange between two entities where each
receives and sacrifices value, such as purchases and sales of goods or services. In short, a
company records as many events as possible that affect its financial position.

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2.1. The Use of Accounts for Recording Transaction
In order to provide the necessary information to users, accountants maintain separate records on
each element of the financial statements. Accounting systems are designed to show the increase
and decrease in each financial statement item in a separate record. This is called an Account.

For example, a separate record is kept for the increase & decrease in cash, supplies, land,
accounts payable, fees earned, salary expenses, e.t.c.

Therefore, Account is a means of accumulating in one place all the information about changes in
a specific asset, liability, owner's equity, expense, or revenue. A file or other record containing
all the separate accounts of a business is called a ledger [a group of accounts for a business
entity].

2.1.1. Classification of Accounts

Accounts in the ledger are customarily listed in the order in which they appear in the financial
statements and are classified according to common characteristics.

Balance sheet Accounts are classified as assets, liability and owner’s equity.
1. Assets: are any physical things (tangible) or right (intangible) that has a monetary value.
Asset is resources that owned/controlled by business enterprise as a result of past transactions
or events from which future economic benefits may be obtained. Assets are classified as
current and fixed assets.
a. Current assets: are those tangible assets that may reasonably be expected to be realized
in cash or sold or used up usually within one year or less, through the normal operations
of the business. Notes receivable, Accounts receivable, Supplies & Prepaid expenses are
currents assets owned by service business. The following are some of the current assets.

 Cash: is any medium of exchange that a bank will accept at face value. It includes -
bank deposits, currency, checks, bank drafts, and money order.
 Notes Receivable (N/R): are claims against debtors evidenced by written promise to
pay a sum of money at definite time.
 Account Receivable (A/R): are also claims against debtors, but are less formal than
notes. They arise from sales of services or merchandise on account.

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  Prepaid Expenses: includes supplies on hand & advance payments of expenses such
as insurance & property taxes.
b. Plant Assets (permanent or fixed assets): are those assets acquired to be used for
relatively long period of time (more than a year). Example, land, machinery, equipment
etc. All plant assets except Land lose their usefulness with the passage of time. This
decline in usefulness is called Depreciation.
c. Intangible Assets: are assets which are used in the operation of business but which have
no physical substance and are noncurrent. Example, Good will, Copyright, patent etc.
2. Liabilities: are debts owed to outsiders (creditors) and are frequently described on the
balance sheet by titles that include the word '' payable ''. Liabilities are also classified as
current and long term liabilities described as follows.
a. Current liabilities: are liabilities that will be due within a short time (usually one year
or less) and that are to be paid out of current assets. Example: Note payable, Account
payable, salaries payable, interest payable, unearned Revenue. Unearned Revenue
means cash received before services are delivered that creates a liability to perform the
services. These future service commitments are often called unearned Revenue.
Example, magazine subscriptions received by publisher & tuition received by a college
etc.

b. Long-term liabilities: are liabilities that will be due for a comparatively long time
(usually more than one year). Example, Mortgage payable (purchases of real estate and
certain types of equipment often are financed by the issuance of mortgage payable).
3. Owner’s equity: is the residual claim against the assets of the business after the total
liabilities are deducted. For corporation, owner's equity is described as stockholder equity.
Income statement accounts include Revenues and Expenses.
1. Revenues: are the gross increases in owner's equity as a result of the sale of merchandise,
the performance of services for a customer or a client, the rental of property and the
lending of money etc.
2. Expenses: are those costs of assets that have been consumed in the process of producing
revenue.

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2.1.2. Chart of Accounts
Accounts are usually arranged/ listed in the ledger in financial statement order i.e. assets first,
followed by liabilities, owner's equity, revenue and expenses. The number of accounts
maintained by a specific enterprise is affected by the nature of its operations, its volume of
business, and the extent to which details are needed for taxing authorities, managerial decisions,
credit purposes etc.

Chart of accounts is a listing of the account titles and account numbers being used by a given
business. In numbering accounts in the ledger, it is preferable to use a flexible system of
indexing so that it permits a later insertion of new accounts in their proper sequence without
distributing the other account numbers. List of accounts in the ledger is called chart of account.

Example: the chart of account of ABC computer center is as follows:

Balance Sheet Accounts Income Statement Accounts

1. Asset 4. Revenue
11 Cash 41 Fees earned
12Account Receivable
14Supplies
15Prepaid Insurance
17Land
18Office equipment
2. Liabilities 5. Expenses
21 Account Payable 51Rent Expenses
23 Unearned Rent 52Wages Expenses
3. Owner’s Equity 54 Utilities Expenses
31Nile, capital 55 Supplies Expenses
32Nile, Drawing 59 Miscellaneous Expenses

2.1.3. Nature of an Account

The simplest form of an account (which is called T- account) has three parts:
A title for recording the name of the item
A space for recording increase in the amount of the item in terms of money
A space for recording decrease in the amount of the items in terms of money

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The left side of the account is called the debit side, and the right side is called the credit side.
The amounts entered on the left side are called debits, and the account is said to be debited. The
amount entered on the right side is called credit and the account is said to be credited.

The following is the simplest form of account named as T- Account because of its similarity
with the letter T.

Title Acct No
Left side Right side
Debit side Credit side
Thus, increase in asset is recorded in the debit side and decreases are recorded in the credit
side. Increase in liability and owner’s equity is recorded in the credit side and decreases in
these accounts are recorded on the debit side. Every business transaction affects a minimum of
two accounts. Regardless of the complexity of a transaction or the number of accounts affected,
the sum of the debits is always equal to the sum of the credits. This equality of debit and credit
for each transaction is inherent in the equation (Asset = Liability + Capital). It is also because
of this equality the system is known as double entry accounting.

Revenues and Investments increase owner's equity & the normal balance of revenue is credit
balance whereas Expenses & Drawing decrease owner's equity & their normal balance is debit
balance. The following table summarizes the normal balance of all accounts.

Balance sheet accounts Increase Decrease Normal balance

Asset Debit Credit Debit
Liability Credit Debit Credit
Owner's equity/Shareholder’s
equity/capital
Capital/Capital stock Credit Debit Credit
Retained Earnings Credit Debit Credit
Drawing/Dividends Debit Credit Debit

Income statement Accounts

Revenue Credit Debit Credit
Expense Debit Credit Debit

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2.2. Steps in Accounting Cycle
1. Journalizing
Journalizing is the process of recording business transactions in a journal. The following is the
flow of activities in the first two steps of accounting cycle.

Business Entry recorded in to

Business Transaction Occurs document Entry posted to ledger
journal
prepared

A transaction involves the transfer of something of value between the business and another party
and within the business itself. It is an event of occurrence which results a change in the economic
resources (assets), obligations (liabilities) or residual interest (owner's equity). Transaction can
be external (purchase of equipment) and/or internal (using equipment which is called
depreciation).

The business documents (or source documents) are used in the accounting system as initial input
information for the recording process. Example, sales invoices, checks, freight bills etc.

The source documents normally contain information as to

 The monetary amount to be recorded
 The parties involved
 The terms of the transactions & other relevant information.
A journal is a document used for initial (first) or original recording of the day to day business
transactions. It is often called book of original entry or document of original entry. It is
classified as general journal and special journal.

 General journal: is a general purpose journal listing transactions expressed in terms of

debits and credits to particular accounts. The simplest type of journal.
 Special journal: is a special purposes journal designed to accumulate a single type of
transaction. Example, cash payment journal, sales journal, purchase journal, and cash
receipt journal.
In general, a journal consists of:

 A date column
 A description column to record the accounts

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 A column to list the accounts number (post reference column)
 A debit & credit column for listing the amounts to be recorded as a debit or credit to each
account.
The standard form of the two column journal is:
General Journal Page No.
Date Description Posting Debit Credit
reference
2004 Sep. 1 Debit account title XXXX
Credit account title XXXX
(Explanation)

Procedures in recording transactions in a two column journal

 Recording the date – year, month & day of the first transaction
 Recording the debit account & amount. The debit account is written in the left margin
 Recording the credit account & amount. The credit account is written in the right margin
 Writing explanation about the Nature of the transaction.
In recording a business transaction, answering the following questions based on the transaction
to be recorded may help you:
a. Which accounts are affected?
b. Is each account increased or decreased?
c. Which account is debited and which is credited?
d. Prepare the complete journal entry.
Example: On January 10, 2005, Tamget P.L.C paid Birr 6,000 to its employees as a salary for
the first week of the year. This business transaction will be analyzed and recorded as follows.
a. Which accounts are affected? Answer: Cash and Salary Expense.
b. Is each account increased or decreased? Cash is decreased and salary expense is
increased.
c. Which account is debited and which is credited? Answer: Salary Expense is debited
because increase in expenses is recorded on the debit side. And cash is credited because
decrease in assets is recorded on the debit side.
d. Prepare the complete Journal entry.

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General Journal Page no------
Date Description Posting Debit Credit
reference
2004 sep 1 Salary Expense 6,000
Cash 6,000
(Payment of salary expense)

Illustration:
Hannon Maze opened a law office on October1, of the current year. During the first month of
operations, the business completed the following transactions:
October 1. Hannon deposited $17,950 cash in the business bank account Hannon, Attorney.
3. Purchased supplies, $2,040 on account.
4. Paid $2,400 for three months insurance coverage.
6. Performed legal service for a client and received cash, $2,160.
8. Purchased equipment on cash, $12,000.
12. Prepared legal documents for a client on account, $2,640.
15. Paid secretary’s wage, $1,100.
19. Performed consulting service for a client on account, $2,800.
21. Paid for creditors on account, $1,670
25. Received cash from clients on account, $3,800.
31. Paid secretary’s wages, $1,100.
31. Paid rent expense, $850.
31. Paid telephone expense of $230 and electric expenses of $120 for the month.
31. Paid other miscellaneous expenses $630.
31. Withdrew $1,500 for personal use.
Instruction:
Prepare the complete journal entry for Hannon Company for the month of December?

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Solution:
General Journal Page No.…1……
Date Description P.R Debit Credit
2003 day
October 1 Cash 11 17,950
Hannon capital 17,950
Initial investment
3 Supplies 2,040
Accounts Payable 11 2,040
Purchase of Supplies on account
4 Prepaid Insurance 11 2,400
Cash 2,400
Purchase of insurance policy
6 Cash 2,160
Fees Earned 2,160
Performed service for cash
8 Equipment 12,000
Cash 11 12,000
Purchase of equipment on cash
12 Accounts Receivable 2,640
Fees Earned 11 2,640
Performed service on account
15 Wage Expense 1,100
Cash 11 1,100
Payment of Wages
General Journal Page No……2……
19 Accounts Receivable 2,800
Fees Earned 11 2,800
Performed service on account
21 Accounts Payable 1,670
Cash 11 1,670
Paid cash on account
25 Cash 3,800
Accounts Receivable 11 3,800
Received cash on account
31 Wage Expense 1,100
Cash 11 1,100
Payment of Wages
31 Rent Expense 850
Cash 11 850
Payment of Rent
31 Utilities Expense 350
Cash 11 350
Payment for telephone, electricity
31 Miscellaneous Expenses 630
Cash 11 630
Payment for various expenses

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 31 Drawings 1,500
Cash 11 1,500
Owner withdrawals

2. Posting from the Journal to the Ledger

After the information about a business transaction has been journalized, that information is
transferred to the specific accounts affected by each transaction. This process of transferring the
information is called posting.
Accounts may be put either in the two-column account or four-column account. We will use the
four-column account for our illustration.
The standard form of the four column account is:
Account ___________________ Account number__________

Date Description P.R Debit Credit Balance

Debit Credit

Steps in Posting

 Write the name of the account and its related identification number
 Enter year, month, and date of the transaction in the date column
 Enter the amount by which it is affected in the debit or credit column
 Insert the journal page no in the posting reference column of the account & the account
number in the posting reference column of the journal
 Determine the accounts balance & enter it in the appropriate sub-column of the balance
column.
Note. The P.R Column is used for reference purposes. The P.R column of the journal shows
whether the entry is posted and the account to which it is posted. In the account, the P.R Column
shows the Journal page number from which the entry was brought. The group of accounts used
by an organization is called ledger.
Illustration: to illustrate the posting process, the entries to each account are posted as follows:

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Account: Cash Account number: 11

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 1 1 17,950 17,950
4 1 2,400 15,550
6 1 2,160 17,710
8 1 12,000 5,710
15 1 1,100 4,610
21 2 1,670 2,940
25 2 3,800 6,710
31 2 1,100 5,640
31 2 850 4,790
31 2 350 4,440
31 2 630 3,810
31 2 1,500 2,310
Account: Accounts Receivable Account number: 12

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 12 1 2,640 2,640
19 1 2,800 `5,440
25 2 3,800 1,640
Account: Supplies Account number: 14

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 3 1 2,040 2,040
Account: Prepaid Insurance Account number: 15

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 4 1 2,400 2,400

Account: Equipment Account number: 18

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 8 1 12,000 12,000

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Account: Accounts Payable Account number: 21

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 3 1 2,040 2,040
21 2 1,670 370

Account: Hannon, Capital Account number: 31

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 1 1 17,950 17,950

Account: Hannon, Drawing Account number: 32

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 31 2 1,500 1,500

Account: Fees Earned Account number: 41

Date Item P.R Debit Credit Balance

Debit Credit
2013, Oct. 6 1 2,160 2,160
12 1 2,640 4,800
19 1 2,800 7,600

Account: Rent Expenses Account number: 51

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 31 1 850 850

Account: Wage Expenses Account number: 52

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 15 1 1,100 1,100
31 2 1,100 2,200

Account: Utilities Expenses Account number: 54

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 31 1 350 350

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Account: Miscellaneous Expenses Account number: 59
Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 15 1 630 630

3. The trial balance preparation

After the posting phase is completed, we have to verify the equality of the debit and credit
balances. This is done through the use of the ‘Trial Balance’. A trial balance is a two column
listing of the accounts in the ledger and their balance to make sure that the total of debit balances
equals the total of credit balances. If the two totals agree, the trial balance is called in balance.
Procedures followed in preparing trial balance

 Determine the balance of each account in the ledger

 List accounts that have balance (Debit or Credit) in the order they appear in the ledger, the
left amount column is for debit balance & the right amount column is for Credit balances.
 The debit and Credit balances are totaled to determine their equality
The trial balance for our illustration, Hannon Attorney is presented below. The amounts are
taken from the balances of the accounts after all the transactions have been posted.
Hannon Company
Trial Balance
For the month ended October 31, 2012
Account Title Debit Credit

Cash 2,310
Accounts receivable 1,640
Supplies 2,040
Prepaid Insurance 2,400
Equipment 12,000
Accumulated depreciation
Accounts payable 370
Hannon, Capital 17,950
Hannon, withdrawals 1,500

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Fees earned 7,600
Rent expense 850
Wage expense 2,200
Utilities Expense 350
Miscellaneous expense 630
25,920 25,920

Uses of Trial balance

 To check the equality of total debits & total credits posted to the accounts in the general
ledger
 Some errors can be detected & corrected before financial statements are prepared
 Facilitates preparation of financial statements. Because of all accounts are available in one
place.

Proof provided by the Trial balance

The trial balance doesn’t provide complete proof of the accuracy of the ledger. It indicates only
that the debits and the credits are equal. If the two totals of the trial balance are not equal, it is
probably due to one or more of the following types of errors:

1. Errors in preparing the trial balance, such as:

 One of the column of the trial balance was incorrectly added
 The amount of an account balance was incorrectly recorded on the trial balance
 A debit balance was recorded on the balance as credit or vice versa or a balance was
omitted entirely

2. Errors in determining the account balances, such as:

 A balance was incorrectly computed
 A balance was entered in the wrong balance column

3. Errors in posting to the ledger from the journal, such as:

 An erroneous amount may be posted to the account
 A debit entry may be posted as a credit or vice versa
 A debit or credit posting may be omitted (over looked)

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Limitation of trial balance
Among the types of errors that will not cause an inequality in the trial balance totals are the
following:

 Failure to record or post a transaction

 Journalizing and /or posting erroneous but equal debit & credit

 Journalizing and /or posting a transaction more than ones

 Journalizing and /or posting a transaction correctly but into the wrong account.

Procedures to locate an error

 Verify the accuracy of the trial balance by re-adding the column
 Compare amount in the trial balance with the account balance in the ledger, making certain
that no accounts have been omitted

 Re compute the balance of each account in the ledger

 Verify or check the posting from the journal to the ledger accounts
 Verify the equality of debit and credit entry in the journal

Common Types of Errors

 Transposition: the erroneous rearrangement of digits

Example: Writing 265 as 625 or 562 etc

 Sliding: it is the erroneous movement of one or more spaces to the right or the left

Example: writing 625 as 6.25 or 6,250

Correcting errors

 When an error is discovered in either the journal or the ledger, it must be corrected.

 If the error is discovered in journal entry before posting or if an incorrect amount was
posted to an account, it may be corrected by ruling a single line through the incorrect
amount or account title and writing the correct amount or account title.

 If an amount was posted to the wrong account it is best to correct the error with a
correcting entry.

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Example: The trial balance of Harvey Company, at November 30, 2013, does not balance:

Harvey Company
Trial Balance
November 30, 2013
Cash 8,820
Accounts receivable 17,825
Supplies 1,800
Prepaid Insurance 400
Equipment 22,500
Notes Payable 25,000
Accounts payable 5,000
Harvey, Capital 36,720
Harvey, withdrawals 8,000
Fees earned 59,750
Rent expense 1,800
Wage expense 31,500
Advertising Expense 5,700
Utilities Expense 5,650
135,595 94,870
Investigation of the accounting records reveals that:
a. The balance of cash was understated by $700
b. A cash receipt of $470 was posted as a debit to Cash of $740
c. A credit of $325 to Accounts Receivable was not posted
d. A return of $245 of defective supplies was erroneously posted as a $425 credited to supplies
e. An insurance policy acquired at a cost of $400 was posted as a credit to prepaid insurance.
f. The balance of Notes payable was overstated by $5,000
g. A credit of $910 in Accounts Payable was overlooked when determining the balance of the
account.
h. A debit of $1,000 for a withdrawal by the owner was posted as a debit to wages expense
i. The balance of $18,000 in rent expense was entered as $1,800 in the trial balance

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j. Miscellaneous expense with a balance of $1,100 was omitted from the trial balance
k. Each account has a normal balance.
Required: Prepare a corrected trial balance as of November 30, 2013.

The corrected trial balance is as follows:

Harvey Company
Trial Balance
November 30, 2013
Cash 9,250
Accounts receivable 17,500
Supplies 1,980
Prepaid Insurance 1,200
Equipment 22,500
Notes Payable 20,000
Accounts payable 5,910
Harvey, Capital 36,720
Harvey, withdrawals 9,000
Fees earned 59,750
Rent expense 18,000
Wage expense 30,500
Advertising Expense 5,700
Utilities Expense 5,650
Miscellaneous Expense 1,100
122,380 122,380

4. The Adjusting Process

To measure income, a business must bring the records up to date at the end of the period. This
process is called adjusting the books and it requires special journal entries called adjusting
entries. Accountants have concepts and principles to guide the measurement of income; these are
the accounting period, the matching principle and the revenue recognition principle.

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The Time Period Assumption
Both small and large companies prepare financial statements periodically in order to assess their
financial condition and results of operations. Accounting time periods are generally a month,
a quarter, or a year. Monthly and quarterly time periods are called interim periods. Most large
companies must prepare both quarterly and annual financial statements.

An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins
with the first day of a month and ends twelve months later on the last day of a month. Most
businesses use the calendar year (January 1 to December 31) as their accounting period.

Revenue Recognition Principle

The revenue recognition principle dictates that companies recognize revenue in the accounting
period in which it is earned. In a service enterprise, revenue is considered to be earned at the time
the service is performed.

The Matching Principle

This principle states that the expenses of a period have to be matched with the revenue of that
period regardless of when payment is made. In order to do this, the accrual basis of accounting
requires the use of an adjusting process at the end of the period so that revenues and expenses of
the period will be determined properly. To avoid the problem of net income determination for the
accounting period, revenues earned match with expired costs to generate such revenues for the
period.

The Accrual Basis and Cash Basis of Accounting

The cash basis of accounting: In this 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. Net income
will, therefore, be the difference between the cash receipts (Revenues) and cash payments
(expenses). This method will be used by organizations that have very few receivables and
payables. For most businesses, however, the cash basis is not an acceptable method.

The accrual basis of accounting: Under this method revenues are reported in the period in
which they are earned, and expenses are reported in the period in which they are incurred. For
example, revenue will be recognized as services are provided to customers or goods sold and not
when cash is collected. Most organizations use this method of accounting, also accepted by
GAAP and we will apply this method in this course.

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The Basics of Adjusting Entries
In order for revenues and expenses to be reported in the correct period, companies make
adjusting entries at the end of the accounting period. Adjusting entries ensure that the revenue
recognition and matching principles are followed. Adjusting entries make it possible to report
correct amounts on the balance sheet and on the income statement.

The trial balance, the first summarization of the transaction data, may not contain up-to-date and
complete data. This is true for several reasons:

 Some events are not recorded daily because it is not efficient to do so. For example,
companies do not record the daily use of supplies or the earning of wages by employees.
 Some costs are not recorded during the accounting period because they expire with the
passage of time rather than as a result of daily transactions. Examples are rent, insurance,
and charges related to the use of equipment.
 Some items may be unrecorded. An example is a utility bill that the company will not
receive until the next accounting period.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals. Each of these classes has two
subcategories.

Deferrals

 Prepaid Expenses: Expenses paid in cash and recorded as assets before they are used or
consumed.
 Unearned Revenues: Cash received and recorded as liabilities before revenue is earned.
Accruals

 Accrued Revenues: Revenues earned but not yet received in cash or recorded.
 Accrued Expenses: Expenses incurred but not yet paid in cash or recorded.
Adjusting Entries for Deferrals
Deferrals are either prepaid expenses or unearned revenues. Companies make adjustments for
deferrals to record the portion of the deferral that represents the expense incurred or the
revenue earned in the current period.

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Prepaid Expenses
Because accrual accounting requires that expenses are recognized only in the period in which
they are incurred, these prepayments are recorded as assets called prepaid expenses or
prepayments. When expenses are prepaid, an asset account is increased (debited) to show the
service or benefit that the company will receive in the future. But prepayments can also be
recorded as an expense at the time of payment rather than recording them as an asset.

Examples of common prepayments are insurance, supplies, advertising, and rent. Prepaid
expenses are costs that expire either with the passage of time (e.g., rent and insurance) or
through use (e.g., supplies).

Example: On January 1, 2012, ABC Co. pays $18,000 for a 3-year insurance contract. The
companies have fiscal years ending December 31. For ABC Co., journalize and post the entry on
January 1 and the adjusting entry on December 31.

January 1. Prepaid Insurance ..................... 18,000

Cash.................................................. 18,000

ABC Co. recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a
balance of $18,000 in the December 31 trial balance. Insurance of $6,000 ($18,000/3) expires
each month. Thus, ABC Co. makes the following adjusting entry.

December 31. Insurance Expenses................. 6,000

Prepaid Insurance ........................ 6,000

Example: The supplies account balance at the beginning of the month September was $12,000.
The physical count at the end of the month (September 30) shows that supplies on hand are
$4,000. Thus, supplies used during the month are $8,000. Therefore, the adjusting entry prepared
at the end of the month is:

September 30: Supplies Expenses ................... 8,000

Supplies........................................ 8,000

Depreciation: Companies typically own buildings, equipment, and vehicles. These long-lived
assets provide service for a number of years. Thus, each is recorded as an asset at cost, rather
than an expense, in the year it is acquired. The term of service is referred to as the useful life.

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According to the matching principle, companies then report a portion of the cost of a long-lived
asset as an expense during each period of the asset’s useful life. All plant assets except land lose
their usefulness.

Depreciation is the process of allocating the cost of an asset to expense over its useful life in a
rational and systematic manner. Depreciation is recorded as a debit to depreciation expense and a
credit to Accumulated depreciation. Accumulated Depreciation is a contra account which shows
the depreciation accumulated since the purchase of the plant assets.

Example: At the end of its first year, the trial balance of ABC Co. shows Equipment $30,000.
Depreciation for the year is estimated to be $5,000. Prepare the adjusting entry for depreciation
at December 31,

December 31. Depreciation Expense- Equipment ........................................ 5,000

Accumulated Depreciation- Equipment ................................. 5,000

Unearned Revenues
Unearned revenues represent liabilities created by receiving cash in advance to provide services
or deliver goods in the future. At the time of the cash receipt, we can record by debiting cash and
crediting liability (balance sheet approach) or by debiting the cash received and crediting
revenue (income statement approach). Examples are rent, magazine subscriptions, and
customer deposits for future service. Similarly, colleges consider tuition received prior to the
start of a semester as unearned revenue.

Example: XYZ Advertising Agency received $1,200 on October 1 for advertising services
expected to be completed by December 31. XYZ credited the payment to Unearned Service
Revenue; this account shows a balance of $1,200 in the October 31 trial balance. For XYZ Co.,
journalize and post the entry on October 1 and the adjusting entry on October 31.

October 1.Cash................................ 1,200

Unearned Revenue ................ 1,200

Analysis reveals that the company earned $400 (1,200/3) of those fees in October. Thus, it makes
the following adjusting entry on October 31.

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October 31. Unearned Revenue ............... 400

Service Revenue ......................400

Adjusting Entries for Accruals

Companies make adjusting entries for accruals to record revenues earned and expenses incurred
in the current accounting period that have not been recognized through daily entries.

Accrued Revenues
Revenues earned but not yet 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 are neither billed
nor collected. The former are unrecorded because the earning process (e.g., of interest and rent)
does not involve daily transactions. The latter may be unrecorded because the company has
provided only a portion of the total service.

An adjusting entry for accrued revenues serves two purposes:

 It shows the receivable that exists at the balance sheet date, and
 It records the revenues earned during the period.

Prior to adjustment, both assets and revenues are understated. Therefore, an adjusting entry for
accrued revenues increases (debits) an asset account and increases (credits) a revenue account.

Example: In October ABC Attorney earned $200 for legal services that have not been recorded.
ABC Co. makes the following adjusting entry on October 31.

October 31. Accounts Receivable ................ 200

Service Revenue ........................ 200

Accrued Expenses
Expenses incurred but not yet paid or recorded at the statement date are accrued expenses.
Interest, rent, taxes, and salaries are typical accrued expenses. Accrued expenses result from the
same causes as accrued revenues. In fact, an accrued expense on the books of one company is
accrued revenue to another company.

An adjusting entry for accrued expenses serves two purposes:

 It records the obligations that exist at the balance sheet date, and

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  It recognizes the expenses of the current accounting period.

Prior to adjustment, both liabilities and expenses are understated. Therefore, an adjusting entry
for accrued expenses increases (debits) an expense account and increases (credits) a liability
account.

Example: ABC Company signed a $50,000; 3-month note payable on October 1.The note
requires ABC Co. to pay interest at an annual rate of 12%. ABC Co. makes the following
accrued expense adjusting entry on October 31.

October 31. Interest Expenses .................. 500

Interest Payable........................ 500

Interest = Principal X Rate X Time

= 5,000 X 12% X 1/12 = 500

Summary of Basic Adjustments

Type of adjustment Adjusting entry Effect of omitting adjusting entry on B/S and I/S

Deferred expense Dr…..expense Expenses understated & NI overstated

Cr…….asset Asset and owner’s equity overstated

Deferred revenue Dr…..liability Liability overstated and Owner’s equity understated

Cr…….revenue NI and revenue understated

Accrued expense Dr…..expense Expense understated and NI overstated

Cr…….liability Liability understated and owner’s equity overstated

Accrued revenue Dr…..asset Asset and owner’s equity understated

Cr…….revenue Revenue and NI understated

Depreciation Dr…..deprn expense Expense understated and NI overstated

Cr…….acc deprn Asset and owner’s equity overstated

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5. Preparation of Work Sheet
Worksheet is a multi -columnar sheet of paper used to summarize data needed for preparation of
financial statements, adjusting entries, and closing entries. Worksheet is a large columnar sheet
designed to arrange in convenient form all the accounting data required at the end of the period.

Uses of a Work sheet:

 Reduces the possibility of overlooking the need for an adjustment

 Provides a convenient means of verifying arithmetical accuracy
 provides for the arrangement of data in a logical form
 Provides the source data for the financial statements

The main headings in the worksheet except the account title are: Trail Balance, Adjustment,
Adjusted Trail Balance, Income Statement, and Balance Sheet

Explanation of worksheet columns:

1. The trial balance column: this is the same trial balance we have prepared before. The
trial balance column of the work sheet can be brought direct from the ledger or from a
separate trial balance.
2. The Adjustment column: As mentioned previously, some account balances have to be
adjusted at the end of the year. The accounts in the ledger of our illustration that require
adjustment and the adjusting entry for the accounts are presented below.
3. The Adjusted Trial Balance Column: The accounts that require adjustment are now
adjusted. Transferring the trial balance column amounts combined with the adjustment
column amounts will complete the adjusted trial balance column of the worksheet.
4. The income statement and the balance sheet columns: Transfer the income statement
account balances (revenue & expenses) to the income statement and balance sheet
account balances (Asset, Liability & owners’ equity) to the balance sheet columns.
The trial balance of Hannon Company at October 31, 2012, the end of the accounting period, and
the data needed to determine year-end adjustments are as follows

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 Hannon Company
Trial Balance
For the month ended October 31, 2012
Account Title Debit Credit
Cash 2,310
Accounts receivable 1,640
Supplies 2,040
Prepaid Insurance 2,400
Equipment 12,000
Accumulated depreciation
Accounts payable 370
Hannon, Capital 17,950
Hannon, withdrawals 1,500
Fees earned 7,600
Rent expense 850
Wage expense 2,200
Utilities Expense 350
Miscellaneous expense 630
25,920 25,920

Adjustment data:
a. Inventory of supplies at October 31, $840
b. Insurance premiums expired during the month, $800
c. Depreciation expense on equipment during the month, $1,000
d. Accrued service revenue, $2,300

Instructions:
1. Record the trial balance on a ten column work sheet and complete the work sheet
2. Prepare an income statement, statement of owners’ equity and a balance sheet
3. On the basis of the adjustment data in the worksheet, journalize the adjusting entries
4. On the basis of the data in the worksheet, journalize the closing entries

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 Hannon Company
For the month ended October 31, 20
Work Sheet
Trial Balance Adjustments Adjusted Trial Income Statement Balance Sheet
Balance
Account Title Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 2,310 2,310 2,310
Accounts receivable 1,640 d) 2,300 3,940 3,940
Supplies 2,040 a) 1,200 840 840
Prepaid Insurance 2,400 b) 800 1,600 1,600
Equipment 12,000 12,000 12,000
n
Accumulated depr c) 1,000 1,000 1,000
Accounts payable 370 370 370
Hannon, Capital 17,950 17,950 17,950
Hannon withdrawals 1,500 1,500 1,500
Fees earned 7,600 d)2,300 9,900 9,900
Rent expense 850 850 850
Wage expense 2,200 2,200 2,200
Utilities Expense 350 350 350
Miscellaneous 630 630 630
expense
25,920 25,920
Supplies expense a) 1,200 1,200 1,200
Insurance expense b) 800 800 800
Depr- expense c) 1,000 1,000 1,000
5,300 5,300 29,220 29,220 7,030 9,900 22,190 19,320

Net Income 2,870 2,870

9,900 9,900 22,190 22,190

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 Hannon Company
Income Statement
Month Ended October 31, 2012
Revenue:
Fees Earned . . . . . . . . . . . . . . . . . . . . . . ………… . . . . . . . . . . . . $9,900

Expenses:
Rent expense . . . . . . . . . . .. . . . . . . . . . . . . . . . . . $850
Wage expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200
Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . 350
Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Insurance expense ………………………………... 800
Miscellaneous expense …………………………… 630
Depreciation expense . . . . . . . . . .. . . . . . . . . . . . . 1,000
Total expenses . . . . . . . . . . . . . . . . . . . ……………………..….. (7,030)
Net income . . . . . . . . . . . . . . . . . . . …….... . . . . . . . . . … . . . . . . . . . . . .$2,870

Hannon Company
Statements of Owner’s Equity
Month Ended October 31, 2012
Hannon, capital, October 1, 2012 . . . . . . . . . . . . …………. . . . . . . . . . $17,950
Add: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,870
Less: Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Increase in owner’s equity …………………………………………….. 1,370
Hannon, capital, October 31, 2012 . . . . . . . . . . . . . . ………….. . . . . . .$19,320

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 Hannon Company
Balance Sheet
October 31, 2012
ASSETS LIABILITIES
Current Asset: Current Liabilities
Cash . . . . . . . . . . . . . . .. . . $2,310 Account Payable ………… $370
Accounts receivable . . ... . .3,940 OWNER’S EQUITY
Supplies . . . . . . . . . . . . …. . . 840 Hannon, Capital …….… 19,320
Prepaid insurance . . . . . . . 1,600
Total current asset ……………. $8,690 Total Liabilities & Owner’s Equity 19,690

Plant Asset:
Equipment . . ……………...$12,000
Less: Accum. Depn. ……... (1,000)
Total Assets ……………………$19,690

Adjusting entries:
a. Supplies Expense (↑ expense; debit). . . . . . . . . . . . . . .. . . . . 1,200
Supplies (↓ asset; credit). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
b. Insurance Expense (↑ expense; debit) . . . . . . . . . . . . . . .. . . . . 800
Prepaid Insurance (↓ asset; credit). . . . . . . . . .... . . . . . . . . . . . . 800
c. Depreciation Expense—Equipment (↑ expense; debit). . ... . . . 1,000
Accumulated Depreciation-Equipment (↓ asset; credit) . . . . . 1,000
d. Accounts Receivable (↑ asset; debit) . . . . . . . .. . . . . . . . . . . . 2,300
Fees Earned (↑ revenue; credit) . . . . . . . . . . . . . . . . . . . .. . . . 2,300

6. The closing process

Some of the accounts in the ledger are temporary accounts used to classify and summarize the
transactions affecting capital (owners’ equity). These accounts will be closed after financial
statements are prepared. That is, their balances will be transferred to the Capital account. The
temporary accounts that have to be closed are revenue, expense and withdrawal accounts.

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Steps in closing:

1. 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.
2. Closing expense accounts: Debit the income summary account by the total of expenses
for the period and credit each expense account by its balance.
3. Closing the income summary account: Income summary will be closed to the capital
account. The balance of this account depends on the nature of operation; credit if result is
profit and debit if result is loss.
4. Closing Withdrawal: Debit the owners’ equity account by the total of drawings for the
period and credit the drawing account.

Closing Entries:

October 31. Service Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,900

Income Summary. . . . . . . . … . . . . . . . . . …………..9,900
31. Income Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 7,030
Rent Expense . . . . . . . . . . . . . . . ... …………... . . . . . . 850
Wage Expense . . . . . . . . . . . . . ….................................2,100
Supplies Expense . . . . . . . . . . . . . . . … . . . . ………... 1,200
Insurance Expense ……………………………………… 800
Depreciation Expense.. …….. . . . . . . . . . . … . . ………1, 000
Utilities Expense . . . . . . . . . ………. . . . . . . . . . . . . . . . 350
Miscellaneous Expense …………………..……………. 630
31. Income Summary ($9,900 − $7,030) .................. 2,870
Hannon, Capital . . . . . . . . . . . . . ….......................2,870
31. Hannon, Capital . . . . . . . . . . . . . . . . . …. . . . . . . . 1,500
Hannon, Withdrawals . . . . . . . . . . . …. ………. . 1,500

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 7. Post-Closing Trial Balance
After the closing entries have been journalized and posted, a trial balance is prepared to prove
the equality of the general ledger before recording the New Year’s transactions. It should be
noted that this trial balance includes only balance sheet accounts. This is because the temporary
income statement accounts are closed during the closing process. This trial balance is called the
post-closing trial balance.

Hannon Company
Post-closing Trial Balance
Month Ended October 31, 2012

Account Title Debit Credit

Cash 2,310
Accounts receivable 3,940
Supplies 840
Prepaid Insurance 1,600
Equipment 12,000
Accumulated Depreciation-Equipment 1,000
Accounts payable 370
Hannon, Capital 19,320
20,690 20,690

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