Chapter 2

Accounting cycle for service-giving business

1.1. Using Accounts to Record Transactions
2.1.1Characteristics of an account
The format that is discussed in Chapter 1, where transactions were recorded and summarized in
the accounting equation format is difficult to use when thousands of transactions must be
recorded daily. Thus, 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.

An account is an individual accounting record of increases and decreases in a specific asset,

liability or equity. For example, since cash appears on the balance sheet, a separate record is kept
of the increases and decreases in cash. Likewise, a separate record is kept of the increases and
decreases for supplies, land, accounts payable, and the other balance sheet items. Similar records
would be kept for income statement items, such as fees earned, wages expense, and rent expense.

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. The left side of the account is called the debit side, and the right side is called the credit side.
Title
Left side Right side
Debit Credit
Amounts entered on the left side of an account, regardless of the account title, are called debits to
the account. When debits are entered in an account, 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.

2.1.2 Classification of accounts and chart of account

Accounts are classified into five: assets, liabilities, capital, revenue and expenses. The first three
are called balance sheet accounts and the other two are called income Statement accounts.
Balance Sheet accounts are those reported on the balance sheet at the end of the reporting period
and Income Statement accounts are reported on the Income Statement. The five groups of
account are discussed below

Assets: Assets could be tangible or intangible. Tangible assets are assets having physical
existence, like cash, land, computer, stationery materials. Intangible asset is a contractual
agreement and do not have physical existence. Example: Goodwill, Copyright, patent right. On
the balance sheet, assets are classified into two current assets and noncurrent assets.
Current Assets: are those assets, which can be used, sold, or converted into cash within one
accounting year or operating cycle. Example: cash, supplies, prepayments, receivables etc.
Non-current Asset: All assets other than current assets are called non-current assets. Example:
land, patent right, office equipment, vehicles.

Liabilities: Liabilities are classified into two as current liabilities and non–current liabilities
Current liabilities: The liabilities that are payable within the next (one) accounting year or
operating cycle are known as current liability. Example: Accounts Payable, Rent Payable, Salary
Payable.
Non-Current Liabilities: Debts that are not required to be paid within the next accounting period
or operating cycle. Example long term notes payable.

Capital: The excess of the assets of a business over its liabilities is referred to as capital. It is the
equity of the owner or owners in the business.

Revenue: Are increases in owner’s equity resulting from the main operations of the business.
E.g. Sales, interest income, tuition fee, and sales commission

Expenses: are decreases in owner’s equity in the process of earning revenue. For example, a
hotel has to pay salary (expense) to its workers for the services rendered to clients in order to get
the income from customers (revenue). E.g. Salary, insurance, depreciation, supplies, utilities,
rent etc.

Chart of accounts
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. The balance sheet accounts are usually listed first, in the order of assets,
liabilities, and owner’s equity. The income statement accounts are then listed in the order of
revenues and expenses.

In the chart of accounts, the asset accounts are listed according to their liquidity. Liquidity is the
ease with which an asset can be converted in to cash. Cash is the most liquid asset so it is listed
first.
Chart of Accounts for SOFTBYTE
Balance Sheet Accounts Income Statement Accounts
1. Assets 4. Revenue
1.1 Cash
1.2 Accounts Receivable 4.2 1 service Revenue
1.3 Supplies 5. Expenses
5.1 Wages Expense
1.4 Land 5.2 Rent Expense
1.5 Office Equipment 5.3 advertising expense
5.4 Utilities Expense
2. Liabilities
2.1 Accounts Payable

3. Owner’s Equity
3.1 Capital
3.2 Drawing

2.2 Double-Entry Accounting System and the rule of Debit and Credit
In chapter 1 if you remember that each transaction must affect two or more accounts to keep the
basic accounting equation in balance. In other words, for each transaction, debits must equal
credits. The equality of debits and credits provides the basis for the double-entry system of
recording transactions. Under the double-entry system, the dual (two-sided) effect of each
transaction is recorded in appropriate accounts. This system provides a logical method for
recording transactions.
The double-entry system also helps to ensure the accuracy of the recorded amounts as well as the
detection of errors. If every transaction is recorded with equal debits and credits, the sum of all
the debits to the accounts must equal the sum of all the credits. The double-entry system for
determining the equality of the accounting equation is much more efficient than the plus/minus
procedure used in Chapter 1.
The term debit indicates the left side of an account, and credit indicates the right side. They are
commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease,
as is commonly thought. We use the terms debit and credit repeatedly in the recording process to
describe where entries are made in accounts. For example, the act of entering an amount on the
left side of an account is called debiting the account. Making an entry on the right side is
crediting the account. When comparing the totals of the two sides, an account shows a debit
balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if
the credit amounts exceed the debits.
Having increases on one side and decreases on the other reduces recording errors and helps in
determining the totals of each side of the account as well as the account balance. The balance is
determined by netting the two sides (subtracting one amount from the other).

2.3 The normal balance of account

An account may increase or decrease on the debit side or on the credit side depending on the
nature of the account. The general rule will be expanded as follows:

Increase
(Normal Balance) Decrease
Balance sheet accounts:
Asset Debit Credit
Liability Credit Debit
Owner's Equity:
Capital Credit Debit
Drawing Debit Credit
Income statement
accounts:
Revenue Credit Debit
Expense Debit Credit
Normal balances of accounts: Normal balance refers to the increasing side of an account (Dr.
or Cr.). E.g. the normal balance of all asset accounts is debit

2.4 Analyzing and recording transactions

2.4.1 Recording transactions
When a business transaction takes place, source documents will be obtained and recorded. The
accounting record in which a transaction is initially recorded is known as a journal. The journal
is therefore referred to as “The book of original entry”. The process of recording a business
transaction in the accounting record is called journalizing.
There are three basic steps in the recording process:
1. Analyze each transaction for its effects on the accounts.
2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger
The recording process begins with the transaction. Business documents, such as a sales receipt, a
check, or a bill, provide evidence of the transaction. The company analyzes this evidence to
determine the transaction’s effects on specific accounts. The company then enters the transaction
in the journal. Finally, it transfers the journal entry to the designated accounts in the ledger
The journal makes several significant contributions to the recording process:
1. It discloses in one place the complete effects of a transaction.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors because the debit and credit amounts for each entry can
be easily compared
The Journal commonly used to record all types of transactions is the General Journal. This
Journal includes the following parts, entered step by step.
 The date of the transaction
 The title of the account debited
 The title of the account credited
 The amount of debit and credit
 Brief explanation of the entry or reference to the source document.
Each one set of debits and credits for a transaction is called a journal entry. Look at the
following General Journal and notice where each of the above information is found.
Journal
page_____________
Date Description P.R Debit Credit
Year
Month day Debited account title XXX XX
Credited account title X XX XX
Explanation
There are also other types of Journals known as special journals that are used to record specific
types of transactions. E.g. Cash receipt Journal, Cash payment Journal, Purchase Journal and
Sales Journal
Illustration 2.1: To illustrate how transactions are analyzed and summarized in accounts, we
will use the softbyte company of chapter one
On September 1, shareholders invested €15,000 cash in the corporation in exchange for ordinary
shares, and Softbyte purchased computer equipment for €7,000 cash. The number J1 indicates
that the company records these two entries on the first page of the general journal

It is important to use correct and specific account titles in journalizing. Erroneous account titles
lead to incorrect financial statements. However, some flexibility exists initially in selecting
account titles.

The main criterion is that each title must appropriately describe the content of the account. Once
a company chooses the specific title to use, it should record under that account title all later
transactions involving the account.

SIMPLE AND COMPOUND ENTRIES

Some entries involve only two accounts, one debit and one credit. (See, for example, the entries
in the above illustration. An entry like these is considered a simple entry. Some transactions,
however, require more than two accounts in journalizing. An entry that requires three or more
accounts is a compound entry. To illustrate, assume that on July 1, Tsai Company purchases a
delivery truck costing $420,000. It pays $240,000 cash now and agrees to pay the remaining
$180,000 on account (to be paid later). The compound entry is as follows
The Ledger

The entire group of accounts maintained by a company is the ledger. The ledger keeps in one
place all the information about changes in specifi c account balances. Companies may use
various kinds of ledgers, but every company has a general ledger. A general ledger contains all
the asset, liability, and equity accounts

Posting

Transferring journal entries to the ledger accounts is called posting. This phase of the recording
process accumulates the effects of journalized transactions into the individual accounts. Posting
involves the following steps.

1. In the ledger, enter, in the appropriate columns of the account(s) debited, the date, journal
page, and debit amount shown in the journal.
2. In the reference column of the journal, write the account number to which the debit
amount was posted.
3. In the ledger, enter, in the appropriate columns of the account(s) credited, the date,
journal page, and credit amount shown in the journal.
4. In the reference column of the journal, write the account number to which the credit
amount was posted.
Posting should be performed in chronological order. That is, the company should post all the
debits and credits of one journal entry before proceeding to the next journal entry. Postings
should be made on a timely basis to ensure that the ledger is up to date. The reference column of
a ledger account indicates the journal page from which the transaction was posted. The
explanation space of the ledger account is used infrequently because an explanation already
appears in the journal.
Illustration

Study these transaction analyses carefully. The purpose of transaction analysis is fi rst to identify
the type of account involved, and then to determine whether to make a debit or a credit to the
account. You should always perform this type of analysis before preparing a journal entry. Doing
so will help you understand the journal entries discussed in this chapter as well as more complex
journal entries in later chapters.
Summary Illustration of Journalizing and Posting
2.5 Preparing Trial Balance: its usefulness and limitations

A trial balance is a list of accounts and their balances at a given time. Customarily, companies
prepare a trial balance at the end of an accounting period. They list accounts in the order in
which they appear in the ledger. Debit balances appear in the left column and credit balances in
the right column. The trial balance proves the mathematical equality of debits and credits after
posting. Under the double-entry system, this equality occurs when the sum of the debit account
balances equals the sum of the credit account balances.

A trial balance may also uncover errors in journalizing and posting. In addition, a trial balance is
useful in the preparation of financial statements, as we will explain in the next two chapters.
The steps for preparing a trial balance are:

1. List the account titles and their balances.

2. Total the debit and credit columns.
3. Prove the equality of the two columns.
Illustration shows the trial balance prepared from Yazici Advertising’s ledger. Note that the
total debits (28,700) equal the total credits (28,700).

A trial balance is a necessary checkpoint for uncovering certain types of errors. For example, if
only the debit portion of a journal entry has been posted, the trial balance would bring this error
to light.

Usefulness of a trial balance

 Trial balance ensures that for every debit entry recorded, a corresponding credit entry has
been recorded in the books in accordance with the double entry concept of accounting. If the
totals of the trial balance do not agree, the differences may be investigated and resolved
before financial statements are prepared. Rectifying basic accounting errors can be a much
lengthy task after the financial statements have been prepared because of the changes that
would be required to correct the financial statements.
 Trial balance ensures that the account balances are accurately extracted from accounting
ledgers.
 Trail balance assists in the identification and rectification of errors.
Limitations of a Trial Balance

A trial balance does not guarantee freedom from recording errors, however. Numerous errors
may exist even though the totals of the trial balance columns agree. For example, the 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, or (5) offsetting errors are made in recording the amount of a transaction. As long as
equal debits and credits are posted, even to the wrong account or in the wrong amount, the total
debits will equal the total credits. The trial balance does not prove that the company has
recorded all transactions or that the ledger is correct

Locating Errors

Errors in a trial balance generally result from mathematical mistakes, incorrect postings, or
simply transcribing data incorrectly. What do you do if you are faced with a trial balance that
does not balance? First, determine the amount of the difference between the two columns of the
trial balance. After this amount is known, the following steps are often helpful:

1. If the error is $1, $10, $100, or $1,000, re-add the trial balance columns and recomputed
the account balances.
2. If the error is divisible by 2, scan the trial balance to see whether a balance equal to half
the error has been entered in the wrong column.
3. If the error is divisible by 9, retrace the account balances on the trial balance to see
whether they are incorrectly copied from the ledger. For example, if a balance was $12
and it was listed as $21, a $9 error has been made. Reversing the order of numbers is
called a transposition error.
4. If the error is not divisible by 2 or 9, scan the ledger to see whether an account balance in
the amount of the error has been omitted from the trial balance, and scan the journal to
see whether a posting of that amount has been omitted.
2.6. Adjusting process in accrual accounting

Accrual- versus Cash-Basis Accounting

What you will learn in this chapter is accrual-basis accounting. Under the accrual basis,
companies record transactions that change a company’s financial statements in the periods in
which the events occur. For example, using the accrual basis to determine net income means
companies recognize revenues when they perform the services (rather than when they receive
cash). It also means recognizing expenses when incurred (rather than when paid). An alternative
to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue
when they receive cash. They record an expense when they pay out cash. The cash basis seems
appealing due to its simplicity, but it often produces misleading financial statements. It fails to
record revenue for a company that has performed services but for which the company has not
received the cash. As a result, the cash basis does not match expenses with revenues. Accrual-
basis accounting is therefore in accordance with International Financial Reporting Standards
(IFRS). Individuals and some small companies, however, do use cash-basis accounting. The cash
basis is justified for small businesses because they often have few receivables and payables.
Medium and large companies use accrual-basis accounting.

Adjusting entries are necessary because the trial balance—the first pulling together of the
transaction data—may not contain up-to-date and complete data. This is true for several reasons:

1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of
supplies and the earning of wages by employees.

2. Some costs are not recorded during the accounting period because these costs expire with the
passage of time rather than as a result of recurring daily transactions. Examples are charges
related to the use of buildings and equipment, rent, and insurance.

3. Some items may be unrecorded. An example is a utility service bill that will not be received
until the next accounting period. Adjusting entries are required every time a company prepares
financial statements. The company analyzes each account in the trial balance to determine
whether it is complete and up-to-date for financial statement purposes. Every adjusting entry will
include one income statement account and one statement of financial position account

Types of Adjusting Entries

Adjusting entries are classified as either deferrals or accruals. Each of these classes has two
subcategories
Deferrals:
1. Prepaid expenses: Expenses paid in cash before they are used or consumed.
2. Unearned revenues: Cash received before services 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.
Adjusting Entries for Accruals

Prior to an accrual adjustment, the revenue account (and the related asset account) or the
expense account (and the related liability account) are understated. Thus, the adjusting entry for
accruals will increase both a statement of financial position and an income statement account.

ACCRUED REVENUES

Revenues for services performed 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. These are unrecorded because the earning of interest does not involve daily
transactions. Companies do not record interest revenue on a daily basis because it is often
impractical to do so. Accrued revenues also may result from services that have been performed
but not yet billed or collected, as in the case of commissions and fees. These may be unrecorded
because only a portion of the total service has been performed and the clients will not be billed
until the service has been completed. An adjusting entry records the receivable that exists at the
statement of financial position date and the revenue for the services performed during the period.

In October, Yazici Advertising performed services worth 200 that were not billed to clients on or
before October 31. Because these services are not billed, they are not recorded. The accrual of
unrecorded service revenue increases an asset account, Accounts Receivable. It also increases
equity by increasing a revenue account, Service Revenue, as shown bellow
ACCRUED EXPENSES
Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses.
Interest, taxes, and salaries are common examples of accrued expenses.
Companies make adjustments for accrued expenses to record the obligations that exist at the
statement of financial position date and to recognize the expenses that apply to the current
accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore,
as Illustration bellow, an adjusting entry for accrued expenses results in an increase (a debit) to
an expense account and an increase (a credit) to a liability account.

Summary of adjusting entries

 Accrued revenue: balance before adjustment understated revenue and understated asset
Adjusting entries Dr asset and Cr revenue
  Accrued expense: balance before adjustment expense understated and liability
understated Adjusting entry Dr expense and Cr liability

2.7 Financial Statements and closing procedures

Preparing a worksheet

Accountants often use working papers for collecting and summarizing data they need for
preparing various analyses and reports. Such working papers are useful tools, but they are not
considered a part of the formal accounting records. This is in contrast to the chart of accounts,
the journal, and the ledger, which are essential parts of the accounting system. Working papers
are usually prepared by using a spreadsheet program on a computer.

The work sheet is a working paper that accountants can use to summarize adjusting entries and
the account balances for the financial statements. In small companies with few accounts and
adjustments, a work sheet may not be necessary.

Unadjusted Trial Balance Columns

To begin the work sheet, list at the top the name of the business, the type of working paper (work
sheet) and the period of time next, enter the unadjusted trial balance directly on the work sheet.
The unadjusted trial balance is the trial balance that is prepared before the adjustment process or
the trial balance that is prepared immediately after preparing the ledger.

Adjustments Columns
The adjustments that we explained and illustrated for Net Solutions are entered in the
Adjustments columns. If the titles of some of the accounts to be adjusted do not appear in the
trial balance, they should be inserted in the Account Title column, below the trial balance totals,
as needed.

Adjusted Trial Balance Columns

The adjustment data are added to or subtracted from the amounts in the unadjusted Trial Balance
column. The adjusted amounts are then extended to (placed in) the Adjusted Trial Balance
columns. Total the columns of the Adjusted Trial Balance to verify the equality of debits and
credits.
 Preparing financial statements from a worksheet
The work sheet is an aid in preparing the income statement, the statement of owner’s equity, and
the Statement of Financial position.
Preparation of the statement of financial position from the adjusted trial balance
 Closing entries
At the end of the accounting period, the company makes the accounts ready for the next period.
This is called closing the books. In closing the books, the company distinguishes between
temporary and permanent accounts.
Temporary accounts relate only to a given accounting period. They include all income
statement accounts and the Dividends account. The company closes all temporary accounts at the
end of the period. Those temporary accounts are: all revenue, all expense and dividend account.
In contrast, permanent accounts relate to one or more future accounting periods. They consist
of all statement of financial position accounts, including equity accounts. Permanent accounts are
not closed from period to period. Instead, the company carries forward the balances of permanent
accounts into the next accounting period. Those permanent accounts are: all asset, all liability
and equity account

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. Journalizing and posting closing entries is a
required step in the accounting cycle.
Four closing entries are required at the end of an accounting period. Steps:
 Debit each revenue account for the amount of its balance, and credit Income Summary
for the total revenue.
 Debit Income Summary for the total expenses, and credit each expense account for the
amount of its balance.
 Debit Income Summary for the amount of its balance (net income), and credit the capital
account for the same amount. (The accounts debited and credited are reversed if there is a
net loss.)
 Debit the capital account for the balance of the drawing account, and credit the drawing
account for the same amount.

You should note that Income Summary is used only at the end of the period. At the beginning of
the closing process, Income Summary has no balance. During the closing process, Income
Summary will be debited and credited for various amounts. At the end of the closing process,
Income Summary will again have no balance. Because Income Summary has the effect of
clearing the revenue and expense accounts of their balances, it is sometimes called a clearing
account. Other titles used for this account include Revenue and Expense Summary, Profit and
Loss Summary, and Income and Expense Summary.

It is possible to close the temporary revenue and expense accounts without using a clearing
account such as Income Summary. In this case, the balances of the revenue and expense accounts
are closed directly to the owner’s capital account. This process is automatic in a computerized
accounting system. In a manual system, the use of an income summary account aids in detecting
and correcting errors.

Illustration
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
Yazici Advertising A.S¸. Closes its books monthly
NB: All the closing entries are posted to the ledger.
2.8 Post-closing trial balance and reversing entries
The last accounting procedure for a period is to prepare a trial balance after the closing entries
have been posted. The purpose of the post-closing (after closing) trial balance is to make sure
that the ledger is in balance at the beginning of the next period. The accounts and amounts
should agree exactly with the accounts and amounts listed on the balance sheet at the end of the
period.
After Yazici 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 the 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.

Reversing Entries (optional)

Some of the adjusting entries recorded at the end of an accounting period have an important
effect on otherwise routine transactions that occur in the following period. A typical example is
accrued wages owed to employees at the end of a period. If there has been an adjusting entry for
accrued wages expense, the first payment of wages in the following period will include the
accrual. In the absence of some special provision, Wages Payable must be debited for the amount
owed for the earlier period, and Wages Expense must be debited for the portion of the payroll
that represents expense for the later period. However, an optional entry—the reversing entry—
may be used to simplify the analysis and recording of this first payroll entry in a period. As the
term implies, reversing entry is the exact opposite of the adjusting entry to which it relates. The
amounts and accounts are the same as the adjusting entry; the debits and credits are reversed.
Summary of accounting cycle