Accounting Chap.2

Fundamentals of Accounting –I 2021
Chapter Two:
Accounting Cycle for Service-Giving Business
2. Accounting cycle
The accounting cycle is process or a series of activities that begins with a transaction and
ends with the closing of the books. Because this process is repeated each reporting period it
is referred to as the accounting cycle and includes the following major steps:
1. Identify and Analyze the transaction and events
2. Recording transactions and events in a journal
3. Classifying transactions by posting from the journal to accounts in the ledger
4. Summarizing transactions from the ledger to an unadjusted trial balance
5. Prepare necessary adjusting entries
6. Prepare the adjusted trial balance (completion of the work sheet)
7. Summarize worksheet data in the form of financial statement
8. Closing the accounting records (nominal accounts) to summarize operations of the
accounting period
9. Preparation of post-closing trial balance.
10. Reversing certain adjusting entries (optional)
The steps from 1-4 are performed throughout the accounting period as transactions occur
or in periodic batch processes. The steps from 5-10 are performed at the end of the
accounting period.
2.1. Service giving companies and characterstics of an account
A service giving companies produces and sells intangible benefits or utilities to customers.
Though tangible goods may also sell together with services, the dominant portions in service
transactions are intangible. The products of service giving companies cannot be stored in
most cases and shall be consumed by the receipt of the service at the service center.
Accounting systems are designed to show the increases and decreases in each financial
statement item in a separate record. This record is called an account. For example, since cash
appears on the balance sheet, a separate record is kept of the increases and decreases in cash.
A group of accounts for a business entity is called a ledger. A list of the accounts in the
ledger is called a chart of accounts. The accounts are normally listed in the order in which
they appear in the financial statements.
An account, in its simplest form, has three parts. First, each account has a title, which is the
name of the item recorded in the account. Second, each account has a space for recording
increases in the amount of the item. Third, each account has a space for recording decreases
in the amount of the item. The account form presented below is called a T account because it
resembles the letter T.
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Title
Left side Right Side
Debit Credit
The terms debit and credit mean left and right sides respectively. The left side of an account
is called the debit side and the right side of an account is called the credit side. The word
charge is sometimes is used in similar fashion for the term debit. Amounts entered on the left
side of an account, regardless of the account title, are called debits or charges to the account,
and the account is said to be debited or charged. Amounts entered on the right side of an
account are called credits and the account is said to be credited. Debits and credits are
sometimes abbreviated as Dr. and Cr.
The illustration that follows, receipts of cash during a period of time has been listed vertically
on the debit side of the cash account. The cash payments for the same period have been listed
in similar fashion on the credit side of the account. A memorandum total of the cash receipts
for the period to date, Birr 20,500 may be inserted below the last debit at any time when ever
the information is desired. The figures should be small and written in pencil in order to avoid
any mistakes while additional amount is debited. Such a procedure referred to as Pencil
footing. The total of the cash payments, birr 16,800 may be inserted on the credit side in a
similar fashion. Deduction of the smaller sum from the larger, Birr 20,500- Birr 16,400,
produces cash on hand amount, which is called the balance of the account. The cash account,
as per this illustration is Birr 3, 700. This amount may be inserted in pencil figures next to the
larger pencil footing, which identifies it as a debit balance. The debit balance of Birr 3,700
would have been taken if balance sheet were prepared.
Cash
7,200 2,000
8,800 6,450
4,500 1,900
3,500
3,700 20,500 2, 950
16,800
2.2. Classification of Accounts
Customarily accounts in a ledger are classified according to common characteristics.
Statement of financial position accounts are classified as assets, liabilities, and equity.
Statement of profit or loss and other comprehensive income accounts are classified as
income and expenses.
Financial position
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Assets
A resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity. Assets are customarily divided in two groups for
presentation on the Statement of financial position. The two groups used most often are:
Current assets and Plant assets
An asset should be classified as a current asset when it is expected to be realized in, or is
held for sale or consumption in, the normal course of the entity's operating cycle; or is held
primarily for trading purposes or for the short-term and expected to be realized within twelve
months of the end of the reporting period; or is cash or a cash equivalent asset which is not
restricted in its use. Other than cash, current assets owned by a service business are notes
receivable and accounts receivable and supplies and other prepaid expenses.
The operating cycle of an entity is the time between the acquisition of assets for processing
and their realization in cash or cash equivalents. This is the case even where they are not
expected to be realized within twelve months.
Cash: is any medium of exchange that a bank will accept at face value. Such as; bank
deposits, currency, checks, bank drafts, and money orders.
Notes receivable: are claims against debtors evidenced (backed) by a written promise to pay
a sum of money at a definite time to the order of specified person or bearer.
Accounts Receivable: are also claims against debtors, but less formal than notes. Accounts
receivables arise from sales of services or merchandise on account.
Prepaid expenses: include supplies on hand and advance payments of expenses such as
insurance and property taxes.
Non-current assets include tangible, intangible, operating and financial assets of a long-term
nature. Other terms with the same meaning can be used (fixed and long-term).
Plant Assets are tangible assets that: are held for use in the production or supply of goods or
services, for rental to others, or for administrative purposes; and are expected to be used
during more than one period. Plant assets include equipment, machinery, buildings, and land.
Such assets, except land gradually wear out or otherwise lose their usefulness with the
passage of time. They are said to depreciate.
Liabilities
Liability A present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits.
They are frequently described on the Statement of financial position by titles that include
the word “payable”. The two main categories most often used are.
1. current liabilities and

2. Long term liabilities
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A liability should be classified as a current liability when it is expected to be settled in the
normal course of the entity's operating cycle or held primarily for the purpose of trading.
Current liability is due to be settled within twelve months after the end of the reporting
period. The most common liabilities under this group are notes payable and accounts
payable, these liabilities are exactly similar with receivable counter parts except that the
debtor-creditor relationship is reversed. Other current liability accounts commonly found in
the ledger are salaries payable, interest payable, and taxes payable.
Long-Term liabilities – Liabilities that will not be due for a comparatively long term
(usually more than one year) are called long-term liabilities or fixed liabilities. Such
liabilities become current liabilities as they due within one-year range.
Equity
It is the residual interest in the assets of the entity after deducting all its liabilities. For a
corporate type of business owner’s equity is frequently called stockholders’ equity,
shareholders equity, or stockholders investment.
Capital, Share capital and Retained Earnings – Capital is the owner’s equity in a sole
proprietorship (and partnership). The owner’s equity may also be described as net worth. For
a corporation, Share capital represents the investment of the stockholders’. Retained earnings
constitute accumulated profits (less losses) made by the company and can be distributed to
shareholders as dividends. They too belong to the shareholders, and so are claims on the
resources of the company.
Drawings and Dividends - Drawings represent the amount of withdrawals made by the
owner of a sole proprietorship (and partnership). For corporation, dividends represent the
distribution of earnings to stockholders.
Performance
Profit is used as a measure of performance, or as a basis for other measures (e.g. Earnings
per share). It depends directly on the measurement of income and expenses.
Income
Income is increases in economic benefits during the accounting period in the form of inflows
or enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants. Both revenue and gains are
included in the definition of income. Revenue arises in the course of ordinary activities of an
entity.
Revenue is the gross inflow of economic benefits during the period arising in the course of
the ordinary activities of an entity when those inflows result in increases in equity, other than
increases relating to contributions from equity participants.
Revenue from sales of merchandise is known as sales, other than sales revenues are termed
as professional fee, commissions' revenue, fares earned, and interest income.
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Gains Increases in economic benefits. As such they are no different in nature from revenue.
Gains include those arising on the disposal of non-current assets.
Income also includes unrealized gains e.g. on revaluation of marketable securities.
Expenses
Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrence of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants. Expense includes losses as
well as those expenses that arise in the course of ordinary activities of an entity.
Losses Decreases in economic benefits. As such they are no different in nature from other
expenses. Losses will include those arising on the disposal of non-current assets.
Expenses will also include unrealized losses, e.g. the fall in value of an investment.
2.3. Chart of Accounts
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.
A listing of the accounts in a ledger is called a chart of accounts. As far as possible, the order
of the accounts in the chart of accounts should agree with the order of the items in the
Statement of financial position and the Statement of profit or loss. The accounts are
numbered to permit indexing and also for use as references.
Though accounts in the ledger may be numbered consecutively as a page of a book, a flexible
system of indexing is preferable. The following chart of accounts is for a small service
business, Alem Dry cleaner, each account number has two digits. The first digit indicates the
major division of the ledger in which the account is placed. Accounts beginning with 1
represent assets; 2, liabilities; 3 owner’s equity (owner’s capital and drawing); 4, revenue;
and 5 expenses. The second digit indicates the position of the account within its division. In
such numbering system there is an advantage of later insertion of new accounts in their
proper sequence without disturbing the other account numbers. For a large enterprise with a
number of departments or branches, it is usual for each account number to have four or more
digits.
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Financial position Accounts Performance Accounts

1. Assets 4. Income
11 Cash 41 Sales
12 Accounts Receivable 5. Expense
14. Supplies 51 Supplies expense
14 Prepaid Rent 52 Salary expense
15 Dry Cleaning Equipment 53 Rent expense
18 Accumulated Depreciation 54 Depreciation expense
2. Liabilities 59 Miscellaneous expense
21 Accounts payable
22 Salaries payable
3. Owner’s Equity
31 Alem, capital
32 Alem, Drawing
33 Income Summary
The initial preparation of the ledger based on the chart of accounts is often referred to as
opening the ledger.
2.4. Rules of Debits and Credits
Financial position Accounts
The following two illustrations are presented the manner of recording data in the accounts
and their relationships to the balance sheet. Assume that Biftu A/Mecha establishes a
business venture, to be known as Biftu Equipment Repair, by making an initial deposit of
Birr 30,800 Cash in a bank accounted for the use of the business enterprise. Soon after the
deposit, the balance sheet for the business, in account form would consist of the following
data.
Assets Owner’s Equity
Cash................ Br 30,800 Biftu A/Mecha, Capital....... Birr 30,800
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Each business transaction affects a minimum of two accounts in a balance sheet. The effect
of such a transaction on accounts in the ledger can be illustrated as a Birr 30,800 debit to
cash and a Birr 30,800 credit to Biftu A/Mecha, Capital. This information, at the beginning,
is entered in record called a Journal. Journal is the first book of original entry. In a journal,
the information is stated in formalized manner by listing the title of the account and the
amount to be debited and followed by the amount to be credited. In doing this, the process of
recording transactions in a Journal is said to be journalizing. The form of presentation is
called a journal entry. This can be illustrated as follows:
Cash...................................................... 30, 800
Biftu A/Mecha, Capital........................................ 30,800
Once the data first is recorded in a journal, then the information is transferred to the
appropriate accounts by a process known as pasting. The followings are accounts after the
completion of the posting process.
Cash Biftu A/Mecha, capital
30,800 30,800
Consider that the amount of the asset, which is reported on the left side of the account form
of the balance sheet, is posted to the left (debit) side of cash. The owner’s equity in the
business, which is reported on the right side of the Statement of Financial Position is posted
to the right (credit) side of Biftu, A/Mecha, capital.
Following the first illustration, assume that Biftu purchased a cost of Birr 28,000. Biftu paid
Birr 8,000 in cash by writing a check on the bank account, and agreed to pay the remaining
Birr 20,000within 30 days after the date of the invoice. Up on the completion of this
transaction, the data reported in the Statement of Financial Position would be as follows:
Assets Liabilities
Cash....................... Birr 22,800 Accounts payable............Birr 20,000
Equipment 28,000 Biftu A/Mecha, capital 30,800
Total Assets .............Birr 50,800 Total liability Owners equity Birr 50,800
The effect of the transaction is described as a birr 28,000 (increase) to Equipment, an amount
of Birr 8,000 credit (decrease) to cash, and a Birr 20,000 credit (increase) to Accounts
payable. (An entry composed of two or more debits or of two or more credits is called a
compound journal entry.)
Equipment............................................ 28,000
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Cash......................................... 8,000
Accounts payable.................... 20,000
After the completion of the posting of second transaction, the accounts of Biftu Equipment
Repair appear as follows:
Cash Accounts payable
30,800 8,000 20,000
Equipment Biftu A/Mecha, Capital
28,000 30,800
Consider that the effect of the transaction was to increase one asset account, decrease another
account, and increase a liability account. Consider also that although the amounts, Birr
28,000 Birr 8,000, and Birr 20,000 are different, the equality of debits and credits are kept.
For every business transaction, the sum of the debits is always equal to the sum of the credits.
In a basic accounting equation, A = L + OE the equality of debit and credit for each
transaction are always maintained. Because of its duality such a system is known as double-
entry account.
As per the general rules of debit and credit, the debit is a left hand side, whereas, a credit is
the right side of all accounts whether asset, liability, or owners equity. The term debit and
credit do not mean increase or decrease (it is simply left or right). That is, a debit may be
either an increase or a decrease, depending on the nature of accounts affected. Similarly, a
credit may be either an increase or a decrease, depending on the nature of the account. For
each transaction debits equal to credits and every transaction affects at least two accounts.
The equality of debit and credit provide the basis for the double entry system of recording
transaction. After each transaction is recorded, it is necessary to compare total assets with
total liabilities and owner's equity to determine the equality of the two sides of the accounting
equation. The general uses of debit and credit may, thus, be stated as follows.
Debit may signify Credit may signify

Increase in asset accounts Decrease in asset accounts
Decrease in liability accounts Increase in liability accounts
Decrease in owner’s equity accounts Increase in owner's equity accounts
It is a common practice that, in sole proprietorship business enterprise, the owner may
withdraw cash from the business for personal use. Such withdrawals have the effect of
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decreasing owner’s equity as debits and increasing the withdrawals by the same amount as
debits. Withdrawals are debited to an account in the name of the owner followed by term
drawing. The balance of this account is periodically transferred to the owner’s capital
account. Hence, debits to the drawing account may be thought of as either decreasing
owner’s equity or increasing drawings.
In a corporate form of business enterprise, the dividends account is comparable to the
drawing account of a sole proprietorship. Distributions of earnings to the stockholders are
debited to Dividends, which is periodically transferred to the retained earnings account
Debits to the dividends account have the effect of decreasing owner’s equity or increasing
dividends.
Performance Accounts
The principle of debit and credit in its application to Income and expense accounts is based
on the relationship of these accounts to owner’s equity.
Income increases owner’s equity. The same to as increases in owner’s equity are recorded as
credits; increases in Income during an accounting period are recorded as credits. Expenses
have the effect of decreasing owner’s equity, similarly, just as decreases in owner's equity are
recorded as debits; increases in expense accounts are recorded as debits.
The rules of debit and credit as applied to Income and expense accounts are shown in the
following diagram.
Performance Accounts
Debit for decrease Credit for increase
In owner’s equity in owner’s equity
Expense Accounts Income Accounts
Debit Credit Debit Credit
For for for for
Increases Decreases Decrease increases
At the close of the accounting period, all Income and expense account balances are
transferred to a summarizing account and the accounts are then said to be closed. The
balance, which is, either a net income or net loss for the period is then transferred to the
owner’s capital account (to the retained earnings account for a corporation) and the
summarizing accounts is also closed. Because Income and expense accounts are periodically
closed, they are sometimes called temporary accounts or nominal accounts. All those
accounts balances which are reported in balance sheet are carried forward from year to year
sometimes referred as a real accounts.
2.5. Normal Balances of Accounts
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The sum of the increases recorded in an account is usually equal to or greater than the sum of
the decreases recorded in the account. Due to this reason, the normal balances of all accounts
are positive rather than negative.
The general rules of debit and credit and the normal balances of the different types of
accounts are summarized as follows.
Increase Decrease Normal Balance

Financial position Accounts:
Assets Debit Credit Debit
Liabilities Credit Debit Credit
Owner’s Equity or Stockholders Equity:
Capital/Capital Stock Credit Debit Credit
Retained Earnings Credit Debit Credit
Drawing/Dividends Debit Credit Debit
Performance Accounts:
Income Credit Debit Credit
Expense Debit Credit Debit
2.6. Analyzing and recording transactions

Every business transaction affects at least two accounts. The flow of accounting data from
the time a transactions occurs to its recording in the ledger may be depicted as follows.
Business Business Entry recorded Entry posted

TRANSACTION DOCUMENT IN JOURNAL TO LEDGER
Occurs Prepared
The first records of each transaction, is evidenced by a business document, such as a sales
ticket, a bill, or a cash register tape. Based on the evidence provided by respective business
documents, every transaction is entered in chronological order (date-wise) in a journal. The
amounts of the debits and credits in the journal are then transferred or posted to the accounts
in a ledger.
Two-column Journal
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Depending on the types and volume of business transactions, a business may use a single all-
purpose two-column journal, or it may use a number of multicolumn journals, limiting each
to single types of transaction.
The double-entry accounting system is a very powerful tool in analyzing the effects of
transactions. Using this system to analyze transactions is summarized as follows:
1. Determine whether an asset, a liability, owner’s equity, revenue, or expense is affected
2. Determine whether the affected asset, liability, owner’s equity, revenue or expense
increases or decreases.
3. Determine whether the effect of the transaction should be recorded as a debit or as a
credit in an asset, liability, owner’s equity, revenue or expense account.
Assume that Birr 3,450.50 is received from cash sales for Hidar 1, the asset cash increases
and therefore should be debited for Birr 3,450.50. The revenue account sales also increases
and therefore be credited for Birr 3,450.50. The two-column journal in which the transaction
has been recorded would be presented as follows.
Journal Page 15
Date Description Post Ref. Debit Credit
2000 Cash 3,450 50
Hidar 1 Sales 3,450 50
Two - Column Accounts and Four-Column Accounts

The simple T form of accounts is used primarily for illustration purposes. Additional rulings
to the T form create the standard two-column form as follows:
Account Cash Account No 11
Date Item Post Ref Debit Date Item Post Ref Credit
Account sales Account No 40

Date Item Post Ref Debt Credit Balance
Debit Credit
Among the significant advantages of the four-column account form are the following:
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 Only a single date column is required, with each debit and credit appearing in its
chronological order
 The debit or credit nature of an account balance is more easily determined and noticeable
in the account.
 Just being adjacent, the debit and credit columns, makes it easier to examine the data in
an account.
Posting
The procedure of transferring journal entries to the ledger accounts is called posting. When
posting is done manually, all the debits may be posted first, followed by the credits. The
posting of a debit journal entry or a credit journal entry to an account in the ledger is done in
the following manner:
1. Record the date and the amount of the entry in the account.
2. Insert the number of the journal page in the posting reference column of the account.
3. Insert the ledger account number in posting reference column of the journal.
Illustration
Hamle1. Alem Taye operated a Dry cleaning business at home and now she decided to go
for rented quarters as of Tir 1 and to work full time to her own business which is known as
“Alem Dry Cleaner”. The following assets were invested in the enterprise: Cash Birr 11,000;
accounts receivable, birr 17,100; supplies Birr 4,400 and Dry Cleaning in Equipment birr
47,000. There were no liabilities transferred in the business.
Analysis: All the four assets are increased and debited respectively.
The owners equity in these assets is equal to the sum of the assets, or birr 79,500; hence
Alem Taye, Capital is credited for the amount.
Journal Page 1
Date Description Post Ref Debit Credit
2000 Cash 11 11000 00
Hamle 1 Accounts Receivable 12 17100 00
Supplies 14 4400 00
Dry cleaning Equipment 18 47000 00
Alem Teye, Capital 31 79500 00
Hamile1. Paid Birr 5,400 on a rent contract represent three months rent of the quarters for
the business
Analysis: The asset acquired in exchange for the cash payment is the use of the property for
three months. Hence, the asset prepaid rent increases and is debited for Birr 5,400.
Customarily when a rent for a particular month is prepaid at the beginning of month it is
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debited to the rent expense account at the time of payment so as to avoid the necessity of
transferring the amount from Prepaid Expense to Rent Expense at the end of the month.
2000
Hamle 1 Prepaid rent 15 5400 00
Cash 11 5400 00
Hamle3. Purchased additional Dry cleaning Equipment on account from National Equipment
Co. for Birr 9,000
3 Dray-cleaning
Equipment 18 9000 00
Accounts payable 21 9000 00
Hamle4. Received Birr 7,100 from customers in payment of their accounts

Analysis: the asset cash increases and is debited for Birr 7,100; the asset accounts receivable
decrease and is credited for Birr 7,100.
4 Cash 11 7100 00
Accounts receivable 12 7100 00
Hamle5. Paid Birr 1,500 for a television advertisement

Analysis: Expense accounts are subdivisions of owner’s equity. Increases in expense and
decreases in owner’s equity; thus, an expense account is debited for Birr 1,500. The asset
cash was decreased by the transaction; therefore that account is credited for Birr 1,500. (In
such a situation, usually Miscellaneous Expense account is used because total expenditures
for advertisement are expected to be relatively minor).
5 Miscellaneous Expense 59 1500 00

Cash 11 1500 00
Hamle9. Paid birr 4,000 to National Dry Cleaning company to apply on the Birr 9000 debt
owed to them
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Analysis: the payment of the liability decreases Accounts payable, therefore the account is
debited for Birr 4,000. It also decreases the asset cash, which is credited for Birr 4,000.
9 Accounts payable 21 4,000 00

Cash 11 4000 00
Hamle13. Paid Birr 470 a two weeks salary for the receptionist
Analysis: An expense account is increased and Cash is decreased. Thus, Salary Expense is
debited for Birr 470, and Cash is credited for Birr 470.
13 Salary expense 52 470 00

Cash 11 470 00
Hamle16. Received Birr 5,845 from sales for the first half of Hamle
Analysis: Cash increases and is debited for Birr 5845. The revenue account sales, which is a
subdivision of owner’s equity, increases and is credited for Birr 5,845.
16 Cash 11 5845 00
Sales 41 5845 00
Hamle19. Paid Birr 2,900 for supplies
Analysis: The asset account Supplies increases and is debited for Br. 2,900. The asset
account Cash decreases and is credited for Br. 2,900.
19 Supplies 14 2900 00
Cash 11 2900 00
Hamle27. Paid Birr 470 a two weeks salary for the receptionist
Analysis: Similar to transaction of Hamle 13.
26 Salary expense 52 470 00

Cash 11 470 00
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Hamle30. Paid Birr 367 for electric, telephone, and water bills for a month
Analysis: similar to transaction of Hamle 5.
30 Miscellaneous Expense 59 367 00

Cash 11 367 00
Hamle30. Received Birr 5,735 from sales for the second half of Hamle
Analysis: similar to transaction of Hamle 5
Journal Page 2
Date Description Post Ref Debit Credit
2000
Hamle 30 Cash 11 5735 00
Sales 41 5735 00
Hamle30. Sales on account totaled Birr 3925.

Analysis: the asset Accounts Receivable increases and is debited for Birr 3,925. The revenue
account sales increases and is credited for Birr 3,925. (When customers pay their accounts,
Cash will be debited and accounts receivable will be credited)
30 Accounts receivable 12 3925 00

Sales 41 3925 00
Hamle30. Alem withdrew Birr 2,500 for her personal use.
Analysis: the withdrawals of cash resulted in a decrease in the owner’s invested capital and
are recorded by a birr 2,500 debit to Alem Taye, Drawing; the decrease in cash is recorded
by a Birr 2,500 credit to cash.
30 Alem Taye, Drawing 32 2500 00

Cash 11 2500 00
After the completion of the postings of all the entries for the month, the ledger will appear as
shown below. The accounts are numbered according to the chart of accounts.
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Account Cash Account No. 11

POST BALANCE
DATE ITEM REF DEBIT CREDIT DEBIT CREDIT
2000 1 1 11000 00 11000 00
Hamle
1 1 5400 00 5600
4 1 7100 00 12700 00
5 1 1500 00 11200 00
9 1 4000 00 7200 00
13 1 470 00 6730 00
16 1 5845 00 12575 00
19 1 2900 00 9675 00
27 1 470 00 9205 00
30 1 367 00 8838 00
30 2 5735 00 14573 00
30 2 2500 00 12073 00
Account Accounts Receivable Account No. 12

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 17100 00 17,100 00
Hamle
4 1 7100 00 10,000 00
30 2 3925 00 13,925 00
Account Supplies Account No. 14

Post Balance
Debit Credit
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Date Item Ref Debit Credit
2000 1 1 4400 00 4400 00
Hamle
19 1 2900 00 7300 00
Account Prepaid Rent Account No 15

Post Balance
2000
Hamle 1 1 5400 00 5400 00
Account Dry Cleaning Equipment Account No.18

Post Balance
2000 1 1 47000 00 47000 00
Hamle
3 1 9000 00 56000 00
Account Accounts payable Account No 21

Post Balance
2000 3 1 9000 00 9000 00
Hamle
9 1 4000 00 4000 00 5000 00
Account Alem Taye Capital Account No. 31

Post Balance
Debit Credit
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Date Item Ref Debit Credit
2000 1 1 79500 00 79500 00
Hamle
Account Alem Taye, drawing Account No 32

Post Balance
2000 30 2 2500 00 2500 00
Hamle
Account Sales Account No 41

Post Balance
2000 16 1 5845 00 5845 00
Hamle
30 2 5735 00 11580 00
30 2 3925 00 15505 00
Account Salary Expense Account No 52

Post Balance
2000
Hamle 13 1 470 00 470 00
27 1 470 00 940 00
Account Miscellaneous Expense Account No. 59

Post Balance
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2000 5 1 1500 00 1500 00
Hamle
30 1 367 00 1867 00
2.7. Preparing a Trail Balance

The equality of debits and credits in the ledger is known as trail balance. In such verification,
the summary listing of both the balances and the titles of the accounts is also useful in
preparing the financial statements. The illustrations for Alem Dry cleaners are as follows:
Alem Dry Cleaners
Trial Balance
Hamle 30, 2000
Cash 12073 00
Accounts receivable 13925 00
Supplies 7300 00
Prepaid rent 5400 00
Dry-cleaning equipment 56000 00
Accounts payable 5000 00
Alem Taye, capital 79500 00
Alem Taye, Drawing 2500 00
Sales 15505 00
Salary expense 940 00
Miscellaneous expense 1867 00
100,005 00 100,005 00
Preparing the trial balance is one of the primary ways to discover errors in the ledger.
However the trial balance does not assure a complete proof of the accuracy of the ledger. It is
simply a test of the equality of debits and credits in a ledger. The following types of errors
may cause a trial balance not to balance;
1. Error in the preparation of the trail balance:
 One of the columns of the trial balance was erroneously computed
 The amount of an account balance was wrongly recorded on the trial balance
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 A debit balance was recorded on the trial balance as a credit, or vice versa, or a
balance was omitted entirely.
2. Error in determining the account balances, such as:
 Incorrect computation of a balance
 A balance was entered in the wrong balance column
3. Error in recording a transaction in the ledger, such as:
 An incorrect amount was posted to the account
 A debit entry was posted as a credit, or vice versa
 An omission of a debit or a credit posting
Numerous errors may exist even though the trial balance columns are in-balance i.e. there are
errors that will not cause the trial balance totals to be unequal. Such as, the trial balance may
balance even when:
1. Failure to record a transaction or to post a transaction (complete omission).
2. Recording the same erroneous amount for both the debit and the credit parts of a
transaction.
3. Recording the same transaction more than once.
4. Posting a part of a transaction correctly as a debit or credit but to the wrong account.
Errors in the accounts may be discovered in various ways: (1) through audit procedures, (2)
by looking at the trial balance or (3) by chance. If the two trial balance totals are not equal,
the amount of the difference between the totals should be determined before searching for the
error.
The amount of the difference between the two totals of a trial balance sometimes gives a clue
as to the nature of the error or where it occurred. For example, a difference of 10, 100, or
1,000 between two totals is often the result of an error in addition. A difference between
totals can also be due to omitting a debit or a credit posting. If the difference can be evenly
divided by 2, the error may be due to the posting of a debit as a credit, or vice versa. For
example, if the debit total is Birr 20,640 and the credit total is Birr 20,236, the difference of
Birr 404 may indicate that a credit posting of Birr 404 was omitted or that a credit of Birr 202
was incorrectly posted as a debit.
Two other common types of errors are known as transpositions and slides. A transposition
occurs when the order of the digits is changed mistakenly, such as writing Birr 542 as Birr
452 or Birr 524. In a slide, the entire number is mistakenly moved one or more spaces to the
right or the left, such as writing Birr 542.00 as Birr 54.20 or Birr 5,420.00. If an error of
either type has occurred and there are no other errors, the difference between the two trial
~ 20 ~
balance totals can be evenly divided by 9. If an error is not revealed by the trial balance, the
steps in the accounting process must be retraced, beginning with the last step and working
back to the entries in the journal. Usually, errors causing the trial balance totals to be unequal
will be discovered before all of the steps are retraced.
Correction of Errors
The procedures used to correct an error in journalizing or posting vary according to the
nature of the error and when the error is discovered.
1. If the journal entry is incorrect but not posted –draw a line through the error and insert
correct titles or amounts.
2. If the journal entry is correct but posted incorrectly – draw a line through the error and
post correctly.
3. If the journal entry is incorrect and posted – journalize and post a correcting entry.
To illustrate, assume that on May 5 a Birr 12,500 purchase of office equipment on account
was incorrectly journalized and posted as a debit to Supplies and a credit to Accounts
Payable for Birr 12,500. Prepare the correct entry.
Correcting entry
May 31 Office Equipment 12, 500
Supplies 12, 500
2.8. The adjusting process-accrual vs. cash basis of accounting
A business must determine what assets, liabilities, and owner’s equity should be reported on
its balance sheet. It must also determine what revenues and expenses should be reported on
its income statement.
When accountants prepare financial statements, they are assuming that the economic life of
the business can be divided into time periods. Using this accounting period concept,
accountants must determine in which period the revenues and expenses of the business
should be reported.
To determine the appropriate period, accountants will use either 1) the cash basis of
accounting or 2) the accrual basis of accounting.
Under the cash basis, revenues and expenses are reported in the income statement in the
period in which cash is received or paid. For example, fees are recorded when cash is
received from clients, and wages are recorded when cash is paid to employees. The net
income (or net loss) is the difference between the cash receipts (revenues) and the cash
payments (expenses).
Under the accrual basis, revenues are reported in the income statement in the period in
which they are earned. For example, revenue is reported when the services are provided to
~ 21 ~
customers. Cash may or may not be received from customers during this period. The concept
that supports this reporting of revenues is called the revenue recognition concept.
Under the accrual basis, expenses are reported in the same period as the revenues to which
they relate. For example, employee salaries are reported as an expense in the period in which
the employees provided services to customers, and not necessarily when the salaries are paid.
The accounting concept that supports reporting revenues and related expenses in the same
period is called the matching concept, or matching principle. The accrual basis requires an
analysis and updating of some accounts when financial statements are prepared.
Nature of the Adjusting Process
At the end of an accounting period, many of the balances of accounts in the ledger can be
reported, without change, in the financial statements. For example, the balance of the cash
account is normally the amount reported on the balance sheet. Some accounts in the ledger,
however, require updating. For example, the balances listed for prepaid expenses are
normally overstated because the use of these assets is not recorded on a day-to-day basis.
There are two possible effects on the ledger when the daily reduction in the balance of
prepaid expenses is not recorded: (1) asset accounts are overstated and (2) expense accounts
are understated.
The journal entries that bring the accounts up to date at the end of the accounting period are
called adjusting entries. All adjusting entries affect at least one income statement account
and one balance sheet account. Thus, an adjusting entry will always involve revenue or an
expense account and an asset or a liability account. Four basic items required to know when
an adjusting entry is needed.
The first two items are deferrals. Deferrals are created by recording a transaction in a way
that delays or defers the recognition of an expense or revenue, as described below.
Deferred expenses, or prepaid expenses, are items that have been initially recorded as
assets but are expected to become expenses over time or through the normal operations of the
business. Supplies and prepaid insurance are two examples of prepaid expenses that may
require adjustment at the end of an accounting period. Other examples include prepaid
advertising and prepaid interest.
Examples:
As per Alem’s trial balance, the balance in the supplies account on Hamle 30 is Birr 7,300.
Assuming that the inventory of supplies on Hamle 30 is determined to be Birr 5000 the
amount of supplies used (transferred to expense account) is computed as follows:
Supplies available (balance of account)............... Birr 7,300
Supplies on hand (inventory) ............................... 5,000
Supplies used (amount of adjustment)................. Birr 2,300
~ 22 ~
Adjusting entry
Supplies expense 2,300
Supplies 2,300
Alem’s prepayments for rent covering for three months have a debit balance of Birr 5,400 on
Hamle 1. At the end of Hamle, the potion belongs to Hamle is one-third (1/3) of the total
balance of prepaid Rent. Thus the rent expense account should be increased (debited) and the
prepaid rent account should be decreased (credited) by Birr 1800.
Adjusting entry
Rent expense 1800
Prepaid rent 1800
If adjustments are not made for the previous illustration supplies (Birr 2,300) and rent (Birr
1800), the effect on the financial statements prepared on Hamle 30 will be incorrect to the
extent indicated below:
i) Statement of profit or loss
- Expenses will be understated............................... Birr 4,100
- Net income will be overstated ............................ 4,100
ii) Statement of Owner’s Equity
- Net income will be overstated.............................. Birr 4,100
- Ending owner’s equity will be overstated. ........... 4,100
iii) Statement of Financial Position
- Assets will be overstated............................................. Birr 4,100
- Owner’s equity will be overstated............................... 4,100
Plant Assets lose their capacity to provide useful services with the passage of time. This
decrease in usefulness is a business expense, which is called depreciation. The depreciation
expense account is debited and the accumulated depreciation account is credited. An
accumulated depreciation account is a contra account because it is “offset against” another
account. It helps to record depreciation since the acquisition of the plant assets.
Typical titles for plant asset accounts and their related contra asset accounts are as follows.
Plant Assets Contra Asset
Land ................................................. -
Buildings............................................ Accumulated Depreciation – Buildings
Equipment......................................... Accumulated Depreciation – Equipment
~ 23 ~
The adjusting entry to record depreciation for Hamle for Alem Dry Cleaners is illustrated as
follows.
The estimated amount of depreciation for the month is assumed to be Birr 4,500.
Adjusting entry
Ham 30 Depreciation Expense 4,500
Accumulated Depreciation 4,500
The Birr 4,500 increase in the accumulated depreciation account represents a subtraction
from the Birr 56,000 cost recorded in the related plant asset account. The difference between
the two balances is the unexpired or is called the book value of the asset. Presentation of
book value on the balance sheet may be shown in the following manner.
Plant Assets:
Dry Cleaning Equipment............................................ Birr 56,000
Less: Accumulated depreciation................................. (4,500) Birr 51,500
If the depreciation of Birr 4,500 is not recorded, the financial statement of Hamle 30 will be
incorrectly affected to the extent shown below.
i) Statement of profit or loss

- Expenses will be understated............. Birr 4,500
- Net income will be overstated ............ 4,500
ii) Statement of Owner’s Equity:
- Net income will be overstated............ Birr 4,500
- Ending owner’s equity will be overstated 4,500
iii) Statement of Financial Position
- Assets will be overstated.................... Birr 4,500
- Owner’s equity will be overstated ...... 4,500
Deferred revenues, or unearned revenues, are items that have been initially recorded as
liabilities but are expected to become revenues over time or through the normal operations of
the business. An example of deferred revenue is unearned rent. Other examples include
tuition received in advance by a school, an annual retainer fee received by an attorney,
premiums received in advance by an insurance company, and magazine subscriptions
received in advance by a publisher.
~ 24 ~
The second two items that require adjusting entries are accruals. Accruals are created by an
unrecorded expense that has been incurred or unrecorded revenue that has been earned, as
described below.
Accrued expenses, or accrued liabilities, are expenses that have been incurred but have not
been recorded in the accounts. An example of an accrued expense is accrued wages owed to
employees at the end of a period. Other examples include accrued interest on notes payable
and accrued taxes.
The data in the following T accounts were taken from the ledger of Alem dry Cleaners. The
debits of Birr 470 on Hamle 13 and 27 in the salary expense account were biweekly
payments on alternate Fridays for the payroll periods ended on those days. The salaries
earned on Monday and Tuesday, Hamle 29 and 30, total Birr 94. This amount is an additional
expense of Hamle and is debited to the salary expense account. In the mean time it is also a
liability as of Hamle 30 and hence credited to salaries payable.
Adjusting entry
Ham 30 Salary expense 94
Salaries payable 94
The debit balance of the salary expense account is Birr 1,034, which are the adjusted amount
and also the actual expense for the month. On the other hand, the credit balance of Birr 94 is
salaries payable is the amount of liability for salaries owed as of Hamle 30. If adjustment for
salaries Birr 94 is not recorded, the effect on the financial statements as of Hamle 30 will be
incorrect to the extent indicated as follows:
Statement of profit or loss:

Expenses will be understated......................................... Birr 94
Net income will be overstated ........................................ 94
Statement of Owner’s Equity:
Net income will be overstated........................................ Birr 94
Ending owner’s equity will be overstated ...................... 94
Statement of Financial Position
Liabilities will understate............................................. Birr 94
Owner’s equity will be overstated................................ 94
Accrued revenues, or accrued assets, are revenues that have been earned but have not been
recorded in the accounts. An example of accrued revenue is fees for services that an attorney
has provided but hasn’t billed to the client at the end of the period. Other examples include
~ 25 ~
unbilled commissions by a travel agent, accrued interest on notes receivable, and accrued
rent on property rented to others.
Note
If cash is received (for revenue) or paid (for expense) in the current period, but the revenue or
expense relates to a future period, the revenue or expense is a deferred item. If cash will not
be received or paid until a future period, but the revenue or expense relates to the current
period, the revenue or expense is an accrued item.
2.9. Preparing a worksheet
It is a common practice that before journalizing and posting adjustments, is necessary to
determine and assemble the relevant data. A preliminary draft of financial statements, and
other useful analyses prepared by accountants are generally called working papers.
A typical working paper frequently used by accountants prior to preparation of financial
statements is called a work sheet. Even though a work sheet is not a permanent record like
that of a journal and a part of a ledger, it has great importance with respect to reducing the
possibility of overlooking the need for adjustment, allows a convenient means of verifying
arithmetical accuracy, provided for the arrangement of data in a logical form, and helps as a
plan for the preparation of financial statements.
The work sheet is having three lines as a heading. That can be identified by: (1) the name of
the enterprise, (2) the nature of the form (work sheet), and (3) the period of time involved.
A work sheet has also a form usually used as an account title column and ten money columns
arranged in five pairs of debit and credit columns. The following are main headings of the
five sets of money columns of a worksheet.
- Trial Balance - Profit or loss

- Adjustments - Financial Position
- Adjusted Trail Balance
Trial Balance Columns
Alternatively, the trial balance data can be assembled directly on the work sheet form or they
may be prepared on a separate sheet first and then copied on the work sheet form. The work
sheet for Alem Drycleaners, with the trial balance data recorded is shown on the following
page.
Adjustments Columns
Both the debit and credit parts of an adjustment should be inserted on the appropriate lines
before extending to another adjustment. Cross-referring the related debit and credit of each
adjustment by letters is useful for the purpose of reviewing the worksheet. Moreover, it is
helpful later when the adjusting entries are recorded in a journal.
~ 26 ~
If the titles of some of the accounts to be adjusted do not appear in the trial balance because
of having zero balance before adjustment, they should be inserted in the account title column,
below the trial balance totals.
~ 27 ~
Alem Dry cleaning

Work sheet for the month ended hamle, 30, 2000
Account Title Trial balance Adjustments Adjusted total balance Profit or loss
Debit Credit Debit Credit Debit Credit Debit Credi
Cash 12073 00 12073 00
Accounts 13925 00 13925 00
receivable
Supplies 7300 00 (a)230 00 5000 00
0
Prepaid rent 5400 00 (b)180 00 3600 00
0
Dry cleaning 56000 00 56000 00
equipment
Accounts payable 5000 0 5000 0
0 0
Alem Taye, 79500 0 79500 0
Capital 0 0
Alem taye, 2500 00 2500 00
drawing
Sales 15505 0 15505 0 1550
0 0 5
Salary expense 940 00 (d) 94 00 1034 00 1034 0
0
Miscellaneous 1867 00 1867 00 1867 0
expense 0
10000 00 10000 0
5 5 0
Supplies expense (a)230 00 2300 00 2300 0
0 0
Rent expense (b)180 00 1800 00 1800 0
0 0
Depreciation (c)450 00 4500 4500 0
expense 0 0
~ 28 ~
Accumulated ©4500 00 4500 0
Depreciation 0
Salaries payable (d) 94 00 94 0
0
8694 00 8694 00 10459 00 10459 0 11501 0 1550
9 9 0 0 5
Net Income 4004 0
0
15505 0 1550
0 5
~ 29 ~
1. Supplies: The supplies account has a debit balance of Birr 7,300 and the cost of the supplies
on hand at the end of the period is Birr 5,000. Thus, the supplies expense for Hamle is the
difference between the two amounts or Birr 2,300. the adjustment is entered by writing (1)
supplies expense in the account title column, (2) Birr 2,300 in the adjustments debit column on
the same line, and (3) Birr 2,300 in the adjustments credit column on the line with supplies.
2. Rent: The prepaid rent account has a debit balance of Birr 5,400 which represents a payment
of three months beginning with Hamle therefore; the rent expense for Hamle is Birr 1,800. The
adjustment is entered by writing (1) rent expense in the account title column (2) Birr 1,800 in the
adjustments debit column on the same line, and (3) Birr 1,800 in the adjustments credit column
on the line with prepaid rent.
3. Depreciation: Depreciation of the Dry cleaning Equipment is estimated at Birr 4,500 for a
month. This expired portion of the cost of the equipment is both an expense and a reduction in
the asset. The adjustment is entered by writing (1) depreciation expense in the account title
column, (2) Birr 4,500 in the adjustments debit column on the same line, (3) accumulated
depreciation in the account title column, and (4) Birr 4,500 in the adjustments credit column on
the same line.
4. Salaries: Salaries accrued but not paid at the end of Hamle amount to Birr 94. This is an
increase in the expense and an increase in liabilities. The adjustment is entered by writing (1)
Birr 94 in the adjustments debit column on the same line with salary expense, (2) salaries
payable in the Account title column, and (3) Birr 94 in the adjustments credit column on the
same line.
The last step in completing the adjustment columns is to prove the equality of debits and credits
by totaling and ruling the two columns.
Adjusted Trial Balance Columns
The data in the Trial Balance columns are combined with the adjustments data and extended to
the adjusted trial balance columns as indicated on the work sheet for Alem Dry Cleaners. For
example, the cash and accounts receivable accounts are extended at their original amounts of
Birr 12,073 and Birr 13,925, since no adjustments affected either account. Supplies has an initial
balance of Birr 7,300 and a credit adjustment (decrease) of Birr 2,300 the amount to be extended
is the debit balance of birr 5000. The same procedure is continued until all account balances have
been extended to the adjusted trial balance columns. The debit and credit columns are then
totaled to prove that no arithmetical errors have been made up to this point.
Profit or loss and Financial Position Columns
The data in the adjusted trial balance columns are extended to one of the remaining four columns
as indicated on the work sheet for Alem Dry Cleaners. The amounts of assets, liabilities, owner’s
equity, and drawing (or dividends) are extended to the Financial Position columns, and the
incomes and expenses are extended to the Profit or loss Columns.
In the illustrative work sheet, first account listed is cash and the balance appearing in the
Adjusted Trial Balance debit column is Birr 12,073 this amount should be extended to the
30
appropriate column. Cash is an asset, it is listed on the Financial Position, and it has a debit
balance. Accordingly, the Birr 12,073 amount is extended to the debit column of the Balance
Sheet section. The balance of Accounts Receivable is extended in similar manner. The Birr 5000
adjusted balance of supplies is extended to the Financial Position debit column. The same
procedure is continued until all account balances have been extended to the appropriate columns.
The balances of the capital have been extended to the appropriate columns. The balances of the
capital and drawing accounts are extended to the Financial Position columns, because this work
sheet does not provide for separate statement of owner’s equity columns.
After all balances have been extended, each of the four columns is totaled. The net income or the
net loss for the period is the amount of the difference between the totals of the two columns of
profit or loss. If the credit column total is greater than the debit column total, the excess is the net
income. For the work sheet presented, the Computation of net income is as follows:
Total of credit column (revenue)............................... Birr 15,505
Total of Debit column (expenses)............................. 11,501
Net income (excess of revenue over expenses)......... Birr 4,004
Income and expense accounts, which are subdivisions of owner’s equity, are temporary in nature.
They are used during the accounting period to aid in the accumulation of detailed operating data.
After they have served their purpose, the net balance will be transferred to the capital account (or
the retained earnings account) in the ledger. This transfer is accomplished on the worksheet by
entries in the profit or loss debit column and the financial position credit column, with the
description of the amount, “Net Income,” inserted in the account title column. If there had been a
net loss instead of a net income, the amount would have been entered in the profit or loss credit
column and the financial position debit column, and described as “Net Loss” in the account title
column.
After the last entry is made on the work sheet, each of the four statement columns is totaled to
verify the arithmetic accuracy of the amount of net income or net loss transferred from the
income statement to the balance sheet. The totals of the two columns of profit or loss must be
equal, as must the totals of the two financial position columns. The work sheet may be expanded
by the addition of a pair of columns solely for the changes in equity (or retained earnings) data.
Preparing Closing Entries
At the end of the accounting period, the company transfers temporary account balances to the
permanent equity account, Retained Earnings, by means of closing entries. Closing entries
formally recognize in the ledger the transfer of net income (or net loss) and Dividends to
Retained Earnings. The retained earnings statement shows the results of these entries. Closing
entries also produce a zero balance in each temporary account. The temporary accounts are then
ready to accumulate data in the next accounting period separate from the data of prior periods.
Permanent accounts are not closed.
31
Journalizing and posting closing entries is a required step in the accounting cycle. The company
performs this step after it has prepared financial statements. In contrast to the steps in the cycle
that you have already studied, companies generally journalize and post closing entries only at the
end of the annual accounting period. Thus, all temporary accounts will contain data for the entire
year.
In preparing closing entries, companies could close each income statement account directly to
Retained Earnings. However, to do so would result in excessive detail in the permanent Retained
Earnings account. Instead, companies close the revenue and expense accounts to another
temporary account, Income Summary, and they transfer the resulting net income or net loss from
this account to Retained Earnings.
Companies record closing entries in the general journal. A center caption, Closing Entries,
inserted in the journal between the last adjusting entry and the first closing entry, identifies these
entries. Then the company posts the closing entries to the ledger accounts.
Companies generally prepare closing entries directly from the adjusted balances in the ledger.
They could prepare separate closing entries for each nominal account, but the following four
entries accomplish the desired result more efficiently:
1. Debit each revenue account for its balance, and credit Income Summary for total revenues.
2. Debit Income Summary for total expenses, and credit each expense account for its balance.
3. Debit Income Summary and credit Retained Earnings for the amount of net income. If there
were a net loss (because expenses exceeded revenues), entry would be reversed: There would
be a credit to Income Summary and a debit to Retained Earnings.
4. Debit Retained Earnings for the balance in the Dividends account, and credit Dividends for
the same amount.
CLOSING ENTRIES ILLUSTRATED
In practice, companies generally prepare closing entries only at the end of the annual accounting
period. However, to illustrate the journalizing and posting of closing entries, we will assume that
Alem Taye Dry Cleaning co. closes its books monthly.
Ham 30 Service revenue 15505
I/summary 15505
Ham 30 I/summary 11501
Salary expenses 1034
Mis. Expenses 1867
Supp. expenses 2300
Rent expenses 1800
Dep. Expenses 4500
32
Ham 30 I/summary 4004
A.T. capital 4004
Ham 30 A.T. capital 2,500
Withdrawal 2,500
Preparing a Post-Closing Trial Balance
After company has journalized and posted all closing entries, it prepares another trial balance,
called a post-closing trial balance, from the ledger. The post-closing trial balance lists permanent
accounts and their balances after journalizing and posting of closing entries. The purpose of the
post-closing trial balance is to prove the equality of the permanent account balances carried
forward into the next accounting period. Since all temporary accounts will have zero balances,
the post-closing trial balance will contain only permanent— statement of financial position—
accounts. Note that all temporary accounts have zero balances after posting the closing entries. In
addition, you should realize that the balance in Retained Earnings represents the accumulated
undistributed earnings of the corporation at the end of the accounting period. This balance is
shown on the statement of financial position and is the ending amount reported on the retained
earnings statement. Company uses the Income Summary account only in closing. It does not
journalize and post entries to this account during the year.
Alem Dry Cleaners
Post-Closing Trial Balance
For Month Ended Hamle 30, 2000
Debits Credits
Cash 12,073
Accounts receivable 13,925
Supplies 5,000
Prepaid rent 3,600
Dry cleaning equipment 56,000
Accounts payable 5,000
Alem Taye, Capital 81,004
Accumulated depreciation 4,500
Salary payable 94
90,598 90,598
A post-closing trial balance provides evidence that the company has properly journalized and
posted the closing entries. It also shows that the accounting equation is in balance at the end of
33
the accounting period. However, like the trial balance, it does not prove that company has
recorded all transactions or that the ledger is correct. For example, the post-closing trial balance
still will balance even if a transaction is not journalized and posted or if a transaction is
journalized and posted twice.
There are also two optional steps in the accounting cycle. As you have seen, companies may use
a worksheet in preparing adjusting entries and financial statements. In addition, they may use
reversing entries, as explained below.
Reversing Entries—an Optional Step
After preparing the financial statements and closing the books, it is often helpful to reverse some
of the adjusting entries before recording the regular transactions of the next period. Such entries
are reversing entries. Companies make a reversing entry at the beginning of the next accounting
period. Each reversing entry is the exact opposite of the adjusting entry made in the previous
period. The recording of reversing entries is an optional step in the accounting cycle.
The purpose of reversing entries is to simplify the recording of a subsequent transaction related
to an adjusting entry. For example, the payment of salaries after an adjusting entry resulted in
two debits: one to Salaries Payable and the other to Salaries Expense. With reversing entries, the
company can debit the entire subsequent payment to Salaries Expense. The use of reversing
entries does not change the amounts reported in the financial statements.
Reversing Entries Example
Companies most often use reversing entries to reverse two types of adjusting entries: accrued
revenues and accrued expenses. To illustrate the optional use of reversing entries for accrued
expenses, we will use the salaries expense transactions for Alem Taye dry cleaner as illustrated
in above.
The transaction and adjustment data are as follows.
1. Hamle 30 (initial salary entry): Alem dry pays 940 of salaries earned between Hamle 13 and
Hamle 27.
2. Hamle 30 (adjusting entry): Salaries earned between Hamle 28 and Hamle 30 is 94. The
company will pay these in the Nehasse 13 payroll.
3. Nehasse 13 (subsequent salary entry): Salaries paid are 470. Of this amount, 94 applied to
accrued salaries payable and 376 were earned between Nehasse 1 and Nehasse 13.
1. Ham 30 Salary expense 940
Cash 940
2. Ham 30 Salary expense 940
Salary payable 940
3. Neh 1 Salary payable 940
34
Salary expense 940
Correcting Entries—an Avoidable Step
Unfortunately, errors may occur in the recording process. Companies should correct errors, as
soon as they discover them, by journalizing and posting correcting entries. If the accounting
records are free of errors, no correcting entries are needed.
You should recognize several differences between correcting entries and adjusting entries. First,
adjusting entries are an integral part of the accounting cycle. Correcting entries, on the other
hand, are unnecessary if the records are error-free. Second, companies journalize and post
adjustments only at the end of an accounting period. In contrast, companies make correcting
entries whenever they discover an error. Finally, adjusting entries always affect at least one
statement of financial position account and one income statement account. In contrast, correcting
entries may involve any combination of accounts in need of correction. Correcting entries must
be posted before closing entries.
35

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Fundamentals of Accounting –I 2021

1. current liabilities and

Financial position Accounts Performance Accounts

30,800 8,000 20,000

Equipment Biftu A/Mecha, Capital

Debit may signify Credit may signify

Increase Decrease Normal Balance

2.6. Analyzing and recording transactions

Business Business Entry recorded Entry posted

Two - Column Accounts and Four-Column Accounts

Account sales Account No 40

Hamle4. Received Birr 7,100 from customers in payment of their accounts

Hamle5. Paid Birr 1,500 for a television advertisement

5 Miscellaneous Expense 59 1500 00

9 Accounts payable 21 4,000 00

13 Salary expense 52 470 00

26 Salary expense 52 470 00

30 Miscellaneous Expense 59 367 00

Hamle30. Sales on account totaled Birr 3925.

30 Accounts receivable 12 3925 00

30 Alem Taye, Drawing 32 2500 00

Account Cash Account No. 11

Account Accounts Receivable Account No. 12

Account Supplies Account No. 14

Account Prepaid Rent Account No 15

Account Dry Cleaning Equipment Account No.18

Account Accounts payable Account No 21

Account Alem Taye Capital Account No. 31

Account Alem Taye, drawing Account No 32

Account Sales Account No 41

Account Salary Expense Account No 52

Account Miscellaneous Expense Account No. 59

2.7. Preparing a Trail Balance

i) Statement of profit or loss

Statement of profit or loss:

- Trial Balance - Profit or loss

Alem Dry cleaning

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