CHAPTER TWO

Information Processing
and Accounting Cycle
 Introduction
Accounting has been called the “language of
business" because it is a method of communicating
business information.
It is undergoing continuous changes to develop
better means of communication.
The accounting process consists of three major
parts:
i. the recording of transaction during the
accounting period,
ii. the summarizing of information at the end of
the period, and
iii. the preparation of financial statements.
 Introduction
Financial accounting is a set of concepts
for identifying, recording, classifying, and
interpreting transactions and other events
relating to enterprises.
Ledger: is the book containing the accounts.

A general ledger is a collection of all the

asset, liability, owners’ equity, revenue, and
expense accounts.
 Introduction (Cont…)
Journal: the “book of original entry”
where the company initially records
transactions and selected other events
Entering transaction data in the journal is
known as journalizing
A subsidiary ledger contains the details
related to a given general ledger account.
Posting: is the process of transferring the
essential facts and figures from the book of
original entry to the ledger accounts.
 (Cont…)
Trial Balance: is the list of all open
accounts in the ledger and their balances.
 At the end of each accounting period an
unadjusted trial balance of the ledger is
prepared
It provides evidence that an equality of
debits & credits exist in the general ledger
The trial balance taken immediately after
all adjustments have been posted is called an
adjusted trial balance.
 (Cont…)
A trialbalance taken immediately after
closing entries have been posted is called a
post-closing (or after-closing) trial balance.
Adjusting Entries:- Entries made at the end
of an accounting period to bring all accounts
up to date on an accrual basis, so that the
company can prepare correct financial
statements.
Debits and Credits
The terms debit (Dr.) and credit (Cr.)
mean left and right, respectively.
 (Cont…)
After the process of recording business
transactions, and summarizing in order to
prepare financial statements,
Unadjusted trial balance prepared,
Then adjusting entries are required to bring the
accounting records up-to-date.
Some adjustments must be made to the recorded
data for changes that have occurred since the
transactions were recorded;
other adjustments are needed for events that have
not been recorded but affect the financial
position and operating results of enterprise.
 2.1. Recording Business Transactions and
Events
For accounting information to be reliable and
relevant, transactions must be interpreted in
conformity with GAAP and accurately.
Transactions and events may be classified in to two
broad groups:
1. External transactions and events , or those
between the business enterprise and other part,
2. Internal events such as recording of
depreciation of plant assets and the recognition
of estimated doubtful accounts expense so on.
2.1. Recording … (Cont…)
Documents are essential for the initial
recording of transactions in various journal
and also used for subsequent tracing and
verification,
Proper design and use of supporting
documents is an important element in the
system of internal control.
2.1.1. Double Entry System
a company records the dual (two sided)
effect of each transaction in appropriate
accounts.
 2.1.1. Double Entry (Cont…)
Double-entry system is in practically universal
use; its name is from the fact that “equal debit
and credit entries” for every event.
the journal entry for transaction is composed of
two parts: one or more debits
and one or more credits.
All journal entries made with the frame work of
the basic accounting equation
(Assets= liabilities + Owner's Equity).
 Each transaction must be analyzed in terms of
its effect on the elements of this equation.
2.1.1. Double Entry (Cont…)
Advantages of the double entry system include:
Built-in controls that automatically call
attention to many types of errors and offer
assurance.
 The terms debit and credit related to the basic
accounting equation (A= L+OE)
Normal balance-Debit = Normal balance –credit
Asset accounts = Liability accounts + Owners‘ Equity
Accounts
2.1.1. Double Entry (Cont…)
One source of change in owner's equity is the
change in the net asset (assets minus liabilities)
as a result of operations, measured by two classes
of ledger accounts- revenue &expenses.
Revenue accounts measure the inflows of assets
resulting from the production and distribution of
goods and services to customers.
Expense accounts measure the outflows of assets
necessary to produce and distribute these goods
and services.
Normal balance-Debit Normal balance –credit
Expense accounts Revenue accounts
 (Cont…)
 For the needs of users; the time period
assumption requires that changes in a business's
financial position be reported over a series of
short time periods.
 Although the reporting period varies, the normal
accounting period is one year. Some companies
use a calendar year, and others use a fiscal - year
end (a 12-month period).
 A calendar year accounting period ends on
December 31 ; all other 12 month periods are
known as fiscal years.
 Reports issued for shorter periods, like one
quarter or one month, called interim reports.
 2.1.2. Accounting Cycle
The accounting cycle is a complete sequence of accounting
procedures. The system includes the following steps:
1. Recording business transactions and events in the journals
2. Classifying data by posting from the journals to the
ledgers
3. Summarizing data from the ledger in an unadjusted trial
balance
4. Adjusting, correcting, and updating recorded data
5. Summarizing adjusted and corrected worksheet data in the
form of financial statements.
6. Closing the accounting records ( nominal accounts) to
summarize the operations of the accounting period
7. Preparation of post closing trial balance
8. Reversing certain adjusting entries to facilitate the
corresponding process in the subsequent accounting
 Illustration
1. October 1: Stockholders invest $100,000 cash
in an advertising venture to be known as
Pioneer Advertising Agency Inc.
2. October 1: Pioneer Advertising purchases
office equipment costing $50,000 by signing a
3-month, 12%, $50,000 note payable.
3. October 2: Pioneer Advertising receives a
$12,000 cash advance from R. Knox, a client,
for advertising services that are expected to be
completed by Dece. 31.
4. October 3: Pioneer Advertising pays $9,000
office rent, in cash, for October.
 Cont…
5.October 4: Pioneer Advertising pays $6,000 for a
one-year insurance policy that will expire next
year on September 30.
6. October 5: Pioneer Advertising purchases, for
$25,000 on account, an estimated 3-month supply
of advertising materials from Aero Supply.
7. October 9: Pioneer Advertising signs a contract
with a local newspaper for advertising inserts to
be distributed starting the last Sunday in
November. Pioneer will start work on the content
of the fl years in November. Payment of $7,000 is
due following delivery of the Sunday papers
containing the fl years.
Cont…
8. October 20: Pioneer Advertising’s board
of directors declares and pays a $5,000
cash dividend to stockholders.
9. October 26: Pioneer Advertising pays $
40,000 employee salaries and wages in
cash.
10. October 31: Pioneer Advertising
receives $28,000 in cash and bills Copa
Company $72,000 for advertising services
of $100,000 performed in October.
Solution
 Activity 1
I. Describe the purpose of the accounting
process
II. Describe the accounting cycle and list the
sequence of procedures involved in the
accounting cycle.
III. Explain the benefits of the double-entry
system
Feed back

I. The purpose of the accounting process is to

provide the users of accounting information with
reliable and timely reports.
II. The accounting cycle is a complete sequence of
procedures that are repeated in the same order
during each accounting period. See procedures
III. a. it gives built in controls that automatically call
attention to many type of errors.
b. offer assurance that once assets are recorded,
they will not be forgotten or over looked.
c) Strengthen the management’s responsibility for
the custody of assets.
d) facilitates the preparation of financial statements
 (Cont…)
Although a small business enterprise can record all
transactions in a single journal (the general journal)
When numerous transactions of the same nature
occur (such as events to receipt of cash), special
journal may be used as a more efficient means of
recording and summarizing.
The great majority of business transactions are of
four types, and data may be recorded by the use of
special multicolumn journals and general journal.
The four most commonly used special journals are;
sales journal, vouchers register (or purchases
journal), cash receipt journal, and cash payments
journal.
 2.1.2.1. Trial Balance
At the end of each accounting period an
unadjusted trial balance of the ledger is
prepared
It provides evidence that an equality of
debits & credits exist in the general ledger.
Activity 2
 What is the purpose of the unadjusted trial
balance?
 Does it provide proof that there have been no
errors in the recording, classifying, and
summarizing of business transactions?
 Feed back:
The primary purpose of the unadjusted trial balance is
to prove the mathematical equality of debits and
credits after posting.
It also uncovers errors in journalizing and posting. In
addition, it is useful in preparation of financial
statements.
However, it does not prove that all transactions have
been recorded or that the ledger is correct. Numerous
errors may exist even though the trial balance columns
agree.
For example, the trial balance may balance even when
a transaction is not journalized, a correct journal entry
is not posted, journal entry is posted twice, and so on.
2.1.2.2. Adjusting Entries
Q1. Accrual Basis of accounting?
Q2. How do we determine net income under this
basis of accounting?

Feed back
 Revenue recognized when realized (earned) and
expense when incurred.
• Net income determined by matching the revenues
earned and expenses incurred. /
Net income= realized revenue minus incurred expenses. /
For revenues to be recorded in the period services
are performed and for expenses to be recognized in
the period they are incurred, companies make
adjusting (follow matching principles).
 2.1.2.2. Adjusting Entries
The use of adjusting entries makes it possible to
report the appropriate balance sheet elements and to
report proper net income (or net loss) for the period.
For the following reasons:
Some events are not journalized daily. Such as
consumption of supplies.
Some costs are not journalized during the
accounting period because they expire with the
passage of time rather than as a result of recurring
daily transactions. Like depreciation
Some items may be unrecorded. Like a utility
service bill that will not be received until the next
accounting period.
 2.1.2.2. Adjusting Entries
Types of Adjusting Entries
Adjusting entries are classified as either
deferrals or accruals.
The deferrals (postponed or delay of service
or goods to be delivered in future)are:
1. Apportionment of recorded costs
Prepaid expenses that are paid cash in
advance before they are used or consumed.
2. Apportionment of recorded revenue
Unearned revenues that Cash received in
advance before services are performed
 2.1.2.2. Adjusting Entries
Types of Adjusting ……
The Accruals (sth accumulated over a period of time
service)are:
3. Accrual of unrecorded expense
Accrued expenses: Expenses incurred but not
yet paid in cash or not recorded.
4. Accrual of unrecorded revenue
Accrued revenues: Revenues for services performed
but not yet received in cash or not recorded

Other type of Adjusting entries

5. Valuation of certain assets and liabilities,
for example accounts receivable
 2.1.2.2. Adjusting (Cont …)
1. Apportionment of recorded costs
Prepaid expenses that are paid cash in
advance before they are used or consumed.
Costs that will benefit more than one
accounting period frequently incurred.
These costs must be apportioned between
periods to usefulness derived from the goods
and services in the realization of revenue; Such
as assets provide service for many years
These assets are recorded at cost, as required
by the cost principle (valuation principle).
 2.1.2.2. Adjusting (Cont …)
According to the matching principle, a portion
of the cost of a long lived asset should be
reported as an expense during each period of
the asset's useful life. Depreciation is the
process of allocating the cost of an asset to the
expense over its useful life,
Periodic depreciation expense is considered a
cost of production. /Record depreciation
expense /
 1. Apportionment of recorded costs
Cost apportionment is also involved in
accounting for all types of prepayments,
Example; Assume supplies are acquired
during the accounting period at a cost of
$6000. At the end of the period of physical
inventory reveals that supplies on hand cost
$2000.
Record the account acquired and adjusting
entry for each of the next approach.
 i. Prepayment Debited to Asset Account

Assets or expenses paid for and recorded

before they are used or consumed are called
prepaid expenses.
When a cost is incurred or expenses are
prepaid, an asset account is debited to show
the service or benefit that will be received
in the future.
Prepaid expenses expire either with the
passage of time (as rent and insurance) or
through consumption (like supplies).
i. Prepayment Debited to Asset ….
The expiration of costs does not require
daily recurring entries that would be
unnecessary and impractical
So at each statement date, adjusting entries
are made to record the expenses.
Record the adjusting entry to transfer
expired portion of the cost of supplies to an
expense account and show the balance of
asset account for the above example?
ii. Prepayments Debited to expense account
If Prepayments are initially debited to an
expense account; adjusting entry is required
to transfer the unexpired portion of the cost
to an asset account.
Record the adjusting entry to transfer
unexpired portion of the supplies to an asset
account by adjusting entry and show the
balance of expense account for the above
example?
2. Apportionment of Recorded Revenue
Unearned revenues that Cash received in advance
before services are performed and goods are
delivered
The liability exists until performance takes place
termed as unearned revenue.
Unearned revenues are opposite of prepaid expenses.
Example, assume that customers paid $400,000
for magazine subscription during the current
accounting period; however, $100,000 represented
payments for magazines to be delivered in the
subsequent periods. The adjusting entries for each
of the next two methods of recording cash receipts
are:
i. Liability Account credited on Receipt of cash
When the payment is received for goods &
services to be delivered in the future period,
unearned revenue (a liability) is credited to
recognize the obligation that exists.
Unearned revenues are subsequently earned
through rendering of service or delivery of
goods to customers.
An adjusting entry is made to record the
revenue that has been earned and to show the
liability that remains.
Adjusting entry to record earned revenue?
ii. Revenue Account credited on receipt of cash
When the cash receipts (advance collection)
were initially recorded as a credit to revenue
account, adjusting entries are required to
transfer the unearned portion of the revenue
to a liability account.
unearned portion of the receipt or amount of
service that is going to be delivered in the
subsequent period ($100,000) should be
debited to the revenue account & recorded as
a liability to recognize the obligation.
Adjusting entry to record unearned revenue?
Adjusting …. Accruals
The Accruals (sth accumulated over a period
of time service).
Accruals to record revenues for services
performed and expenses incurred in the
current accounting period.
3. Accrual of unrecorded expense
Accrued expenses are Expenses incurred but not
yet paid in cash or may not be recorded.
 expenses that accrue with the passage of time
 are recorded only when paid, except when the
end of the period occurs between the time the
expense is incurred and the payment is due
 3. Accrual of unrecorded expense
Prior to adjustment, both liabilities and expenses are
understated.
Thus, adjusting entry for accrued expenses
results in a debit to an expense account and a
credit to a liability account. Example
XY Company signed a one year note payable in
the amount of $60,000 on September 1. The note
requires interest at an annual rate of 6% to be
paid quarterly. On November 30, the company
paid an interest of $900 ($60,000 x 6/100x3/12).
The next interest will be paid on February 28 of
the coming year.
 interest exp. accrued during the month of Dec. ?
4. Accrual of Unrecorded Revenue
Revenues earned (services performed) but not
yet received in cash or recorded at the
statement date are known as accrued revenues.
Interest revenue and rent neither billed nor
collected, they are unrecorded because the
earning of interest and rent does not involve
daily transactions,
Commissions and fees are 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.
 4. Accrual of Unrecorded Revenue
An adjusting entry is required to record the
revenue that has been earned during an
accounting period as well as the receivable
that exist at the balance sheet date
Example, assume that XY Advertising
Company earned $5,000 in fees for
advertising service that were not billed to
clients before December 31. Because these
services have not been billed they have not
been recorded. Record adjusting entry?
 Cont…
Example: Consider also rent revenue of
$2,000 that has been realized but not
collected for the month of December has not
been recorded.
The adjusting entry is required on Dec. 31?
/To record rent earned but not collected/
Example:
1. Assuming the prepayment is debited to asset
account, prepare the adjusting journal entry for
the following situation: full payment of a
$24,000 birr, two-year insurance policy on June
30, 2005, by a firm with December 31 year-end.
2. Prepare the adjusting journal entry for the
situation in (I) assuming the prepayment was
debited to expense.
 5. Valuation of Account Receivable
A policy of making sales on credit result in
some accounts receivables that are
uncollectible.
To achieve a satisfactory matching of
revenues and expenses, estimated expenses
arising from sales on credit should be
recorded in the period when sales occur,
But not in the period in which the accounts
or notes are written off.
5. Valuation of Account Receivable
At the end of each period an estimate is
made of current period revenue on account
that will later prove to be uncollectible.
The estimate is based on the amount of bad
debts experienced in the past years, general
economic conditions, the age of the
receivables, and other factors that indicate
the element of uncollectibility.
Example: assume that experience indicates a
reasonable estimate for doubtful accounts
expense is $3,500. The adjusting entry is?
 2.1.2.3. Closing Procedures
Closing revenue and expense accounts
Revenue and expense ledger accounts are closed at
the end of each accounting period by transferring
their balances to a summary ledger account,
income summary.
By closing revenue and expense accounts, the net
increase or decrease in owners’ equity is
transferred to an appropriate owners equity ledger
account.
Example:- If we assume that a subscriptions
Revenue ledger account after adjustment has a
credit balance of $350. 000,
 2.1.2.3. Closing Procedures
To close an expense ledger account, to the
income summary account.
For example, an interest expense account with
a balance of $6,000 after adjustment is closed:
the entry
Closing Inventory and related Ledger Accounts
End-of- period procedures for inventory depend
on what inventory system is in use.
With a perpetual inventory system, purchases and
sales are recorded directly in the inventory
account as the purchases and sales occur.
Closing Inventory &related Ledger Accounts
Under perpetual the balance in the inventory
account should represent the ending
inventory amount, and
no adjusting entries are needed.
To ensure this accuracy, however, a physical
count of the items in the inventory is
generally made annually.
 Under a periodic inventory system
In a periodic inventory system, a purchase
account is used and the Inventory account is
unchanged during the period .
The Inventory account represents the
beginning inventory amount throughout the
period.
At the end of the accounting period the
Inventory account must be adjusted by closing
out the beginning inventory and recording the
ending inventory.
The Income Summary account represents the
Closing Inventory &related Ledger Accounts
To illustrate, assume that East African Trading has
a beginning inventory of $50,000; purchases
$100,000; Transportation in $10,000; purchase
return and allowances, $2,000; purchase discounts
$6000; &ending inventory, including applicable
transportation- in is $12, 000.
The journal entry to close the accounts and to
record the ending inventory is:
 Some merchandising enterprises prefer to use a
separate ledger account, cost of goods sold, to
summaries the merchandising enterprise’s
accounts when the periodic inventory system is
used.
 Closing the Income summary Account
After all the revenue and expenses (including
the cost of goods sold) have been closed, the
balance of the income summary ledger
account indicates the net income or net loss
for the year.
Finally, income summary closed to retained
earnings ( or owner's equity) account.
 2.1.2.4. Reversing Entries
A reversing entry is made at the beginning of
the next accounting period and is the exact
opposite of the related adjusting entry made in
the previous period.
The purpose of reversing is to simplify the
recording of transactions in the next accounting
period (it does not change amounts reported in
the f/s in previous period.
Reversing entries are most often used to reverse
two types of adjusting entries: accrued revenues
and accrued expenses.
 2.1.2.4. Reversing Entries
To illustrate reversing entry for accrued
expenses assume on July 31, Year 1 Garad
Company borrowed $400,000 at 12% on a
long- term note with interest of $12,000
payable every three months. The first payment
of interest was made on October 31, Year 1;
the next interest payment is due on January
31, Year 2. Before the accounting records are
closed on December 31, year 1, an adjusting
entry is:
Reversing entry is:
The general rules for using reversing entries
When an adjusting entry affects an asset or
liability account that normally is not used
during an accounting period, a reversing
entry is required.
if payments for insurance and supplies
during a period are recorded in the expense
accounts, or if revenue received in advance
during a period is recorded in revenue
accounts, the adjusting entries would have to
be reversed
 The general rules for using reversing entries
When an adjusting entry adjusts an asset or
liability account that normally is used to
record transactions during the period, no
reversing entry is required.
supplies and other short- term prepayments
during a period are recorded in asset
accounts, or if revenue received in advance is
recorded in liability accounts, no reversing
entry would be required.
For depreciation and doubtful accounts
expense, for example, are not reversed.
 Correcting Entries
Correcting journal entries are those journal
entries that are made to correct errors
committed. The function is to correct errors
of omission or commission.
example, assume that errors were made in
Year1 and were discovered at the end when
the work sheet for the year ended December
31, Year1, was being prepared
1. A purchase of merchandise for $500 cash
was erroneously recorded by a debit of $50
to the supplies expense ledger account and a
 Correcting Entries
2. An acquisition of equipment for cash of
$4,000 on April1, Year1 was recorded as a
purchase of merchandise .The equipment had
an economic life of 10 years with no residual
value, and was depreciated by the straight
line method for nine months in year1.
3. Collection of $300 from Ato Solomon from
sale on account has been credited to the
account of Ato Yohannes.
An analysis of the two errors to determine
the appropriate correcting entries follows:
End of Chapter
Two