BITS College

Undergraduate Program

Course Number : SP 311

Course Title: Business Accounting
 Chapter Two

The Accounting Cycle

Defining Accounting Cycle
 An accounting cycle is a process that consists of different phases or
steps where the completion of which is a must to prepare financial
reports or statements periodically.
 The steps include:
 Analyzing transactions
 Recording transactions in a journal
 Posting entries from journal to ledger
 Preparing trial balance
 Adjusting ledger accounts
 Preparing financial statements
 Closing temporary accounts
 Preparing post closing trial balance
Account and Its Analysis
Meaning of an Account
 What is an account?
 Account is a record of increases and decrease in a specific Asset, Liability,
Capital, Revenue and Expense item.

 An account:
 Serves as basic storage unit for accounting data
 Used to accumulate amounts from similar transactions
 Provides detail financial records of an item
Meaning of an Account
▪ What is an Account?
 Is a record of increases and decreases in a specific asset, liability, equity, revenue and
expense item.
 Serves as basic storage units for accounting data in an accounting system
 used to accumulate amounts from similar transactions
 an individual detail accounting record
 an account title should describe what is recorded in the account.
 each element of the Accounting Equation (A, L and E) contains smaller elements called
accounts.

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Meaning of an Account

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Meaning of an Account
• A = L + OE…………………………..Major Classification
• Assets = A1 + A2 +…+ An ………...............General Accounts
• = Cash + Accounts Rec. + Supplies + Equipment + ….
• A1= A/R= AR1+ AR2 +…+ ARn ................Subsidiary Accounts

Liabilities = L1 + L2 + L3 + …+ Ln
• = Accounts Pay. + Salaries Pay. + Loan Pay. + ….

• Owner’s Equity = Revenues - Expenses + Investments –Withdrawals

• =R–E+I–W
• R = R1 + R2 + …+ Rn = Sales R + Rent R + Interest R + …
• E = E1 + E2 + …+ En = Salary E + Repair E + Utilities E + …
Meaning of an Account

▪ Structure or Form of an Account

➢ Simplified version: T-Account form.
✓ It is a tool used to analyze transactions & has three parts
✓ Debit = “Left” ; Credit = “Right”

Account Name/Title
Debit / Dr. Credit / Cr.

Left or Debit Side Right or Credit Side

Meaning of an Account
Standard Form of Account
Meaning of an Account
Major Classification and Sequence of
Ledger Accounts
Major Classification & Sequence of Ledger Accounts

Balance sheet accounts

Assets Liabilities Owner’s Equity

Current Assets Current Liabilities

• For use in one year or • Payable after one year or
operating cycle operating cycle

Noncurrent Assets Noncurrent Liabilities

• For use beyond one year • Payable after one year or
operating cycle operating cycle
Classification and Sequence of Ledger Accounts

Balance sheet accounts

Assets Liabilities Owner’s Equity

Investments

Revenues are increases in Drawings

owner’s equity as a result
of selling services or
products.
Revenues
Expenses are the using up
of assets or consuming of
services to generate
revenue.
Expenses
Classification and Sequence of Ledger Accounts

• Balance sheet accounts: Permanent [Real] accounts that

remain open, with nonzero balances, at the end of the reporting
period (fiscal year).

• Income statement accounts: Temporary [Nominal] accounts

that have a zero balance at the end of the reporting period
(fiscal year)

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Coding/Numbering of Accounts

▪ An account code/number is a tool or method used to identify

the classification and location of an account in the ledger.
▪ Different set of digits could be used. For instance:

Asset accounts : 111 through 199

Liability accounts : 211 through 299
Owner’s Equity accounts : 311 through 399
Revenue accounts : 411 through 499
Expense accounts : 511 through 599

Where: for example

Cash 111 1st digit=Asset, 2nd digit = current assets, and 3rd digit
position in the current assets
 2.1 Coding/Numbering of Accounts

Accounts Receivable - 112 1 1 2

1st digit 2nd digit 3rd digit

Asset Current 2nd position
asset
A/c Payable - 212 2 1 2
3rd digit
1st digit 2nd digit
Current 2nd
Liability
Liability position
Chart of Accounts
Chart of Accounts

▪ In a manual accounting system, each account is kept on a

separate page or card, which are placed together in a book
or file called the general ledger.
▪ In computerized systems, the group of accounts is also called
the general ledger, or simply the ledger.
▪ A chart of accounts
▪ is a table of contents for the ledger.
▪ lists the account titles and the numbers that have been assigned
to them.
▪ lists the accounts in the order in which they appear in the ledger
(the order in which they appear in the financial statements).
Chart of Accounts
Example
Rules of Debit and Credit
Rules of Debits and Credits of an Account

• Double-Entry System - Double-entry accounting demands the accounting

equation remain in balance, which means that for each transaction:
• At least two accounts are involved, with at least one debit and one credit
• Total amount debited must equal total amount credited

Debit (Dr.) Credit (Cr.)

An entry on the left side An entry on the right side

1) An increase in an asset, 1) A decrease in an asset,

2) A decrease in a liability, 2) An increase in a liability,
3) A decrease in an 3) An increase in an
owner’s equity item owner’s equity item
Rules of Debits and Credits of an Account

Owner’s Equity ◆ Owner’s investments and revenues increase

owner’s equity (credit).
Debit / Dr. Credit / Cr.

◆ Owner’s drawings and expenses decrease

Normal Balance owner’s equity (debit).

Chapter
3-25

Owner’s Capital Owner’s Drawing

Debit / Dr. Credit / Cr. Debit / Dr. Credit / Cr.

Normal Balance Normal Balance

Chapter Chapter
3-25 3-23
Rules of Debits and Credits of an Account

Revenue ◆ Purpose of earning revenues is to

Debit / Dr. Credit / Cr.

benefit the owner(s).

Normal Balance ◆ Effect of debits and credits on

Chapter
3-26 revenue accounts is the same as
their effect on Owner’s Capital.
Expense
Debit / Dr. Credit / Cr.
◆ Expenses have the opposite
effect: expenses decrease
Normal Balance
owner’s equity.
Chapter
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Rules of Debits and Credits of an Account

Balance Sheet Income Statement

Asset = Liability + Equity Revenue - Expense

Debit

Credit

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Rules of Debits and Credits of an Account

Relationship among the assets, liabilities and owner’s

equity of a business:
Basic
Assets = Liabilities + Owner’s Equity
Equation

Expanded
Basic
Equation

The equation must be in balance after every transaction. For

every Debit there must be a Credit.
Account Balance
▪Account balance
−The difference between the total debit footing (sum) and the
total credit footing or total.
−If Debits are greater than Credits, the account will have a debit
balance.
Account Name
Debit / Dr. Credit / Cr.

Transaction #1 $10,000 $3,000 Transaction #2

Transaction #3 8,000

Balance $15,000
Account Balance

- If Debits are less than Credits, the account will have a credit
balance.

Account Name
Debit / Dr. Credit / Cr.

Transaction #1 $10,000 $3,000 Transaction #2

8,000 Transaction #3

Balance $1,000
Normal Balances of Accounts
Normal Balance
 Thenormal balance of an account is its usual balance and is
the side (debit or credit) that increases the account.
Analyzing and Recording Transactions
Analyzing and Recording Transactions a
 Inanalyzing transactions, the following three questions need to be
answered:
 What items/accounts affected?
 How the items/accounts affected?
 How they should be recorded in terms of debit ad credit?
 Example 1:
 On Feb. 7, 2023, LMN Co. acquired a plot of land paying Br. 5million cash

 Example 2:
 On Feb. 08, 2023, LMN Co. provided services to customers that worth Br.
500,000 receiving Br. 200,000 cash and the remaining on account
Analyzing and Recording Transactions
 In recording transactions, we use journals. The process of recording
transactions in a journal is called JOURNALIZING.
 There are two types of journals: general and special
 General journals used to record all types of transactions
 Special journal are used to record specific types of transactions.
 In recording transactions in a journal, the following steps need to be
followed:
 Step 1 record the date of the transaction
 Step 2 record the debit entry
 Each record in a journal is called an entry
 Step 3 record the credit entry
 Step 4 write a brief description about the transaction
 Example: record the above transactions using general journal
EXERCISE
Posting
Posting
 Posting is the process of transferring monetary amounts of debit and credit entries from the
general journal to the accounts in the ledger.
 It is necessary to classify and group similar transactions in terms of their effects on specific
asset, liability, capital , revenue and expense items.
 There are two types of ledger accounts: General and Subsidiary
 General ledger includes controlling accounts which will appear in the financial
statements
 Subsidiary ledger contains accounts showing details of general ledger.
 Steps in Posting:
 Step 1 record the date of the transaction on the date column of the ledger account
 Step 2 record the debit entry in the debit amount column of the ledger account
 Step 3 record the credit entry in the credit amount column of the ledger account
 Step 4 write the page number of the journal in the post reference column of the
ledger account
 Step 5 write the account number of the ledger in the post reference column of the
journal
Preparing Trial Balance
Trial Balance
 Trial
Balance is the list of all accounts and their balances at a given
point of time
 Uses:
 Proves the mathematical equality of debits and credits in the ledger after
posting
 Help us to discover errors such as:
 Posting unequal debit and credit amounts for an entry;
 Posting a debit entry as a credit or vice versa;
 Arithmetic mistakes in balancing accounts;
 Clerical errors in copying account balances into the trial balance;
 Listing a debit balance in the credit column of the trial balance or vice versa; and
 Errors in determining the debit and credit totals of the trial balance.
Prepare a trial balance.
Exercises (see exercise I and II)
Limitations of a Trial Balance
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.
5. Offsetting errors are made in recording the amount of a
transaction.

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Adjustments
Adjustments
Adjustment is one of the year end accounting processes.
It refers journal entries that are required in order to produce
correct balances for the financial statements
This is the process used to deal with the disconnect between
transaction timing and actual cash flows

Adjusting entries:
1. Properly measure periodic income on the income statement:
Assign revenues to the period in which they are earned
Assign expenses to the period in which they are incurred
2. Update the asset and liability accounts
3. Includes/consists of one income statement account and one balance
sheet account.
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Adjustments
Rationale (Why/When it occurs?)
 Product of accrual basis of accounting, i.e. recording revenues when
earned and expenses when incurred instead of cash basis of accounting
 Periodicity assumption: business life is divisible into equal intervals of time
called accounting periods for reporting purpose

AP1 AP2 AP3 APn

Business Life

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Adjustments
 Accrual-basis accounting records the effect of every business
transaction as it occurs, regardless of when the cash is received or
paid.
 Cash-basis accounting records transactions only when cash
receipts and cash payments occur.

Records revenues when they are earned/performed

Accrual
Basis
Records expenses when they are incurred/used

Records cash receipts as revenue

Cash Basis
Records cash payments as expenses

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Adjustments
 There are two main types of adjusting entries:
1. Prepaid (Deferred) – key points:
 update/adjust the recorded data
 advance receipts/payments of cash
 cash before performance/use
2. Accruals – key points
• record the unrecorded data
• latter collections/payments of cash (post paid/received)

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2-51
Types of Adjusting Entries

Deferrals:
1. Prepaid expenses: Expenses paid in cash and recorded as assets
before they are used or consumed.
2. Unearned revenues: Cash received before service are
performed.
Accruals:
1. Accrued revenues: Revenues for services performed but not yet
received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or
recorded.
Adjustments Deferrals
I. Deferrals [Adjusting Existing Data]
a) Prepaid Expenses: Advance payments (Expenses paid in advance but not yet
incurred/Payment precedes incurrence)
➢ Asset / Expense Adjustment
➢ Asset xxx Expense xxx
Cash xxx Asset xxx

b) Unearned Revenues: Advance collections (Revenues collected in advance but

not yet earned/Collection precedes earning)
➢ Liability/Revenue Adjustment
➢ Cash xxx Unearned R. xxx
Unearned R. xxx Revenue xxx

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 Adjustments
Prepaid Insurance Example
 Insurance policies are usually PAID for in advance
 On May 1, 2021, EFG purchases an annual insurance policy for Br. 3,600; the
journal entry would be:
Prepaid Insurance 3,600
Cash 3,600

• After one month has passed, the adjusting entry on May 31, 2021 is:
Insurance Expense 300
Prepaid Insurance 300

Correct asset amount, Total accounted for, Correct expense amount, 2-54
Br. 3,300 Br. 3,600 Br. 300
 Adjustments
Supplies Example

 On May 2, 2021, EFG purchases supplies for Br. 1,500 cash. The journal entry would
be:
Supplies 1,500
Cash 1,500
 On May 31, 2021, a physical count of the supplies indicated that Br.1,000 remained;
the adjusting entry would reduce the Supplies asset by Br. 500:
Supplies Expense 500
Supplies 500

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 Adjustments
Amortization of Property, Plant, and Equipment, and Intangible Assets
 Property, plant, and equipment (PPE) are identifiable tangible capital assets (land,
buildings, furniture, vehicles, machinery, and equipment)
 Amortization (depreciation) defined:
 The process of allocating the cost of PPE to an expense account over its
estimated useful life
 Example:
 On May 3, 2021, EFG purchases furniture for Br. 45,000 with an expected life of 5
years. The journal entry, to record the purchase:
Furniture 45,000
Cash 45,000

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Adjustments
• A portion of the furniture’s cost is transferred from the asset account to
Amortization Expense each period the asset is used; after one month, the May 31,
2021 entry is:
Br. 45,000 ÷ 5 years = Br. 9,000 per year.
Br. 9,000 ÷ 12 months = Br. 750 per month.

Depreciation/Amortization Expense – Furniture 750

Accumulated Depreciation/Amortization – Furniture 750

• Accumulated Depreciation (Amortization) – Furniture is known as a contra

account

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Adjustments
 A contra account has:
 a companion account
 a normal balance opposite that of the companion account
 Accumulated Amortization (Depreciation) is a contra account to property,
plant, and equipment assets
 Used to show the cumulative sum of all amortization expense from the date
of acquiring the asset
 It has a normal credit balance

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 Adjustments
Unearned Revenue Example
 EFG receives a cash advance of Br. 3,000 on May 20, 2021 from a customer for a 30
day project
 The journal entry is:

 During the last 10 days of the month—May 21 through May 31— EFG will have earned
one-third (10 days divided by April’s total 30 days) of the Br. 3,000, or Br. 1,000

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Adjustments

Correct liability Total Correct revenue

amount, accounted for, amount,
Br. 2,000 Br. 3,000 Br. 1,000

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Adjustments
 Unearned (Deferred) Revenue
 On Oct. 1, 2021 the Ethiopian Football Federation (EFF) sold 1000 tickets to
its 20 football games for Br. 100 each. The EFF makes the following entry on
Oct. 1


Cash …………………………..…………. 100,000

Unearned Revenue …………………………….. 100,000

 On Dec. 31, 2021, the EFF has played 10 of its regular football games,
winning 2 and losing 8. Record the adjusting entry
Adjustments
 Unearned (Deferred) Revenue
 Adjusting Entry:


Unearned Revenue ………………..50,000

Football Revenue ……………….…..50,000
Adjustments
Accruals
I. Accruals [Recording New Data]
a) Accrued Expenses: Expenses incurred but not yet paid (Use precedes
payment)
➢ Liability/Expense Adjustment
➢ Expense xxx
Liability xxx
b) Accrued Revenues: Revenues earned but not yet collected (Performance
precedes collection)
➢ Asset/Revenue Adjustment
➢ Asset (e.g. A/R) xxx
Revenue xxx
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Adjustments
Accrued Revenue Example
 EFG is hired on May 15 to provide monthly services for Br. 3,000 per month, with
the first payment to be received on June 15. Service is provided from May 15 to
May 30.
 The adjusting entry on May 30 to record two weeks of revenue is:

 Adjusting for accrued revenues illustrates the concept of revenue recognition

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 Adjustments
Accrued Expense Example: Salaries Expense
 EFG pays its two employees a bi-monthly salary of Br. 4,000 in total on the
15th and on the last day of the month
 The employees are paid on May 15, but May 30 is a Saturday: thus
employees will receive their pay cheques on Monday, June 1
 Match the salaries expense to the period with a journal entry on May 30 to
make the accrual:

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Adjustments
 Accrued Expense:
 Exercise:
A Co. pays its employees every Friday. Year-end, Dec. 31, 2022 falls
on Wednesday. As of Dec. 31, 2022, the employees have earned
salaries of Br. 47,250 for Monday through Wednesday.
 Required:
 Record the adjusting entry on Dec. 31, 2022
 Record cash payment on the date of salary payment
2.5 Adjustments

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 2.6 The Work Sheet

Worksheet
◆ A multiple-column form that may be used in the
adjustment process and in preparing financial
statements.
◆ Manual or computer spreadsheet.
◆ A working tool, not a permanent accounting record.
◆ Neither a journal nor a part of the general ledger.

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Closing Entries
 Purpose
 Journal entries that update the owner’s equity account
 Transfer/close the balance of nominal accounts to owner’s equity
account
 Reduce the balance of nominal accounts to zero

 Steps
 Close revenue accounts to income summary account
 Close expense accounts to income summary account
 Close income summary account to owner’s equity
 Close the drawing account to owner’s equity

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End of Chapter Two