CHAPTER TWO

THE ACCOUNTING CYCLE

2.1 Nature of an Account

Although all transactions can be analyzed and recognized in terms of their effect
on accounting equation, such a format is not practical a design for actual
accounting system.

Accountants must provide information on business transactions for use in

directing operations and for the preparation of timely periodic financial
statements. These goals are met by keeping a separate record for each item that
appears on financial statements.

For example, a record would be used only for recoding increases and
decreases in cash, another record would be used only for recording increases
in Supplies, another for Land, Prepaid Rent, Sales, Salary expense, Rent
expense, etc.

The type of record traditionally used for the purpose of recording individual
financial statement items is called an account. A group of related accounts that
comprise a complete unit, such as all of the accounts of a specific business
enterprise, is called a ledger.

2.2 Chart of Accounts

A listing of the accounts in a ledger is called a chart of accounts. The order of items
(accounts) in the chart of accounts should agree with the order of the items in the balance
sheet and the income statement. The accounts are numbered to permit indexing and also
for use as references. For most simple (small) business organization has two digits: The
first digit indicates the major division of the ledger in which the account is placed.
Accounts beginning with 1 represent asset, 2 liabilities, 3 owner’s equity and
drawing, 4 Revenue and 5 expenses. The second digit indicates the position of the
account within its division.

A numbering system of this type has the advantage of permitting the 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 not unusual for
each account number to have four or more digits.

Balance sheet Income statement

1.Assets 4 Income
11 Cash 41Sales
12 Accounts Receivable 5 Expenses
14 Supplies
15 Prepaid Rent 51Supplies Expense
18 Photographic Equipment 52Salary Expense
19 Accumulated Depreciation 53Rent Expense

2. Liabilities 54Depreciation
21 Accounts Payable Expense
22 Salaries Payable 55 Miscellaneous
Expense
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 3. Owner’s Equity
31 X- Capital
32 X- Withdrawal

2.3 Nature of an Account

The simplest form of an account has three parts:
1. A title - This is the name of item recorded in the account.
2. A space for recording increases in the amount of the item, in terms of money, and
3. A space for recording decreases in the amount of the item, in terms of monitory
units.
This form of an account is known as T- account because of its similarity with the letter T.

Title

Left side Right side

Debit Credit

Debit: The left side of an account is called debit.

Credit: The right side of an account is called credit.
The word “charge” is sometimes used as synonym for debit. Amounts entered on
the left side of an account regardless of an account title are called debits or
charges to the accounts and the account is said to be debited or charged. Amounts
entered on the right side of an account called credits and the account is said to be
credited.

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2.4 Rule of Debit and Credit

Every Business transaction affects a minimum of two accounts. For each

transaction the debit amount (or the sum of all debit amounts, if there are more
than one) must equal the credit amount (or the sum of all the credit amounts). This
is known as double–entry system.

It follows that recording of a transaction in which debits do not equal credits is

incorrect. For all the accounts combined, the sum of the debit balances must equal
the sum of credit balances; otherwise, something has been done incorrectly. Thus,
the debit and credit arrangement used in accounting provides a useful means of
checking the accuracy with which the transactions have been recorded.

Double-entry system is based on accounting equation

Assets = Liabilities + Owner’s Equity

For every dollar/birr entered as a debit to one account, a dollar /birr must be entered as a
credit to some other account.

Assets = Liabilities + Owner’s Equity

Debit Side Credit Side
(Positive asset balance) (Positive liabilities and owner’s equity)

All assets increase on the left hand side or debit side; and decrease on the right
hand side or credit side. All Liabilities and Owner’s Equity accounts increase on the
right hand side or credit side and decrease on the left hand side or debit side. This is
known as General rule of debit and credit.
Assets = Liabilities + Owner’s Equity

Debit Credit Debit Credit Debit Credit

+ - - + - +

The rules for recording revenues and expenses are derived from the rules for
owner’s Equity. By definition revenue increases owner’s equity; and we have said
that owner’s equity increases in the right (credit) side. It necessarily follows that
revenues increase in credit side and decrease on debit side.

Expenses are the opposite of revenues in that expenses decrease owners’ equity.
Therefore, it follows that Expenses increase with debit side and decrease with
credit side. Drawing, similar with expense decrease owners’ equity; therefore,
increase with debit side and decrease with credit side.

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 Revenues Expenses
Debit Credit Debit Credit
- + + -

2.5 Nominal or Temporary accounts Vs. Real or Permanent Accounts

Because Revenue and expense accounts are periodically closed, they are sometimes called
Temporary accounts or Nominal accounts. The balances of the accounts reported in the
balance sheet are carried forward from year to year and because of their permanence are
referred to as Real accounts or Permanent accounts. In short, all income statement
accounts are nominal or temporary accounts that are going to be closed to the Balance sheet
account (owner’s Equity). Thus, the normal balance for an asset account is a debit balance
and a normal balance for a liability or owner’s equity account is a credit balance. The normal
balance for an expense account is a debit balance and a normal balance for a revenue account
is a credit balance.

Summary:

Balance sheet Accounts Increas Decrease Norma

e Balance
Assets Credit Debit
Liabilities Debit Debit Credit
Credit
Owners’ Equity Credit Debit Credit

Drawing Debit Credit Debit

Income statement Accounts

Revenue Credit Debit Credit

Expense Debit Credit Debit

Note that when an account that normally has a debit balance actually has a credit balance,
or vice versa, it is an indication of an accounting error or unusual situation. For example,
a credit balances in asset account such as Building, Land, Inventory, Equipment, etc.
could result only from an accounting error. On the other hand, a debit balance in liability
account could result from over payment.

2.6 The process of journalizing and posting transactions

The flow of accounting data from the time a transaction occurs to its recording
in the ledger may be diagramed as follow:

Business Business Entry Entry

TRANSACTIONS DOCUMENT Recorded in Posted to
Occurs ⇒ Prepared ⇒ JOURNAL ⇒ LEDGER

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 The initial record of each transaction, or of a group of similar transactions, is
evidenced by a business document; such as sales ticket, a bill, cash register tape.
On the basis of the evidence provided by the business documents, the
transactions are entered in chronological order in a journal.

The amounts of the debits and the credits in the journal are then transferred to
the accounts in a ledger. This process of transferring the amounts of the debits
and credits from the journal to the accounts in the ledger is known as Posting.

Two-Column Journal

There is great variety in both the design of journals and the number of different journals
that can be employed by an enterprise. A business may use a single all-purpose two-
column journal (general journal) or it may use a number of multi column journals (special
journals), restricting each for a single type of transaction.

 Before a transaction is entered in the two-column journal, it should be

analyzed according to the following sequence of steps:-

1. Determine whether an Asset, a Liability, Owner’s equity, Revenue or Expense

is affected i.e. Determine accounts(s) affected
2. Determine whether the affected, Liability, Owner’s equity Revenue or
Expense increases or decreases i.e. Determine whether the affected account
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 i.e. Determine whether the effect (increase or decrease) should be
recorded as debits or credits.

The process of recording a transaction in a two-column journal is summarized as

follow:

1. Record the date

Insert the year at the top only of the Date Column of each page, except when the year date
change. Insert the month on the first line only of the date column of each page, except when
the month date changes. Insert the day in the date column on the first line used for each
transaction, regardless of the number of transactions during the day.

2. Record the debit

Insert the title the account to be debited at the extreme, left of the description column and
enter the amount in the debit column.

3. Record the credit

Insert the title of the account to be credited below the title of the account debited moderately
indented, and enter the amount in the credit column.

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 .
4. Write an explanation
Brief explanations may be written below each entry. It should be noted that all
transactions are recorded only in terms of debits and credits to specific accounts. The
titles used in the entries should be the same as the titles of accounts in the ledger. The line
following an entry is left blank in order to clearly separate each 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 Debited Account Title xxxxx
Month Credited Account Title xxxxx
Date Explanation

 Each one set of debits and credits for a transaction is called a journal entry.

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Posting from the journal to the Ledger
After the information about a business transaction has been journalized, that information
is transferred to the specific accounts affected by each transaction. This process of
transferring the information is known as posting.

Two – Column Accounts and Four – Column Accounts

A simple form of an account is a T- account illustrated earlier; beside the T- account; The
account could be a two- column account or a four – column account for each of them
look at the following accounts format:-

The two- column account Account No._____________

Date Item P.R Debit Date Item P.R Credit

The Four – Column account

Date Item P.R Debit Credit Balance

Debit Credit

The following are advantages of the four column account form:

1. Only a single date column is required, with each debit and credit appearing in its
chronological order.
2. The debit or credit nature of an account balance is more easily determined and more
prominently displayed in the account
3. Having immediately adjacent debit and credit columns makes it easier to examine
the data in an account.

Steps in Posting:
When posting is done manually, the debits and credits in the journal may be posted in the
order they occur on if many items are to be posted at one time, all the debits may be
posted first, followed by the credits. The posting of a debit or credit journal entry to an
account in the ledger is performed as follow:

1. Record the date and amount of Dr. and Cr. Entry to the account.
2. Insert journal page number in the P.R (Posting Reference) column of the account.
3. Insert the account number in the P.R of the journal.

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Illustration of Journalizing and Posting

Hill Photographic Studio Chart of Accounts:-

1 Asset:
11 Cash
12 Accounts Receivable
14 Supplies
15 Prepaid Rent
18 Photographic Equipment
19 Accumulated Depreciation – Photographic Equipment

2 Liabilities
21 Accounts Payable
22 Salaries Payable
3 Owner’s Equity
31 Ann Hill, Capital
32 Ann Hill, Drawing
33 Income Summary
4 Revenue
41 Sales
5 Expenses
51 Supplies Expense
52 Salary Expense
53 Rent Expense
54 Depreciation Expense
59 Miscellaneous Expense

Transactions

Mar 1, 2020. Ann Hill operated a photographic business her home on a part –time basis.
She decided to move to rented quarters as of March 1 and to devote full time the business
which was to be known as Hill photographic studio. The following assets were invested
in the enterprise; cash, 3500, accounts Receivable 950, supplies 1200; and photographic
equipment 15000. There were no liabilities transferred to the business.
March 1. Paid 2400 on a rental contract, the payment representing three months’ rent of
quarters for the studio
March 4. Purchased additional photographic equipment on account for Birr
2500
March 5. Received 850 from customers in payment of their accounts
March 6. Paid 125 for a newspaper advertisement – Advertising expense considered as
miscellaneous expense by Ann Hill
March 10. Paid 500 for the debt as a result of March 4 transactions
March 13. Paid receptionist 575 for two weeks’ salary
March 16. Received 1,980 from sale of service
March 20. Paid 650 for supplies purchase
March 27. Paid 575 receptionists for two weeks’salary
March 31. Paid 69 for telephone bill for the month

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March 31. Paid 175 for electric bill for the month
March 31. Received 1870 from sales of service
March 31. Make sales on account for 1,675
March 31. Hill withdrew 1500 for her personal use.

Note: Advertising expense, Electric expense, and Telephone expense are classified as
miscellaneous expense by Ann Hill.

Required: Journalize and Post the above transaction.

General Journal Page 1

Date Description P.R Debit Credit

2020 Cash- 3500
March 1 Accounts Receivable 950 00
Supplies 1200 00
Photographic Equipment 15000 00
Ann Hill, Capital 00 20650 00

1 Prepaid Rent 2400 00

Cash 2400 00
4 Photographic Equipment 2500 00
Accounts payable 2500 00
5 Cash 850 00
Accounts Receivable 850 00
6 Miscellaneous Expense 125 00
Cash 125 00
10 Accounts payable 500 00
Cash 500 00
13 Salary Expense 575 00
Cash 575 00
16 Cash 1980 00
Sale 1980 00
20 Supplies 650 00
Cash 650 00
27 Salary Expense 575 00
Cash 575 00
31 Miscellaneous Expense 69 00
Cash 69 00
31 Miscellaneous Expense 175 00
Cash 175 00
31 Cash 1870 00
Sales 1870 00
31 Accounts Receivable 1675 00

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 Sales 1675 00
31 Ann Hill Drawing 1500 00
Cash 1500 00

These Journal Entries are posted to the accounts in the accounts in the ledger as follow:
Account Cash Account No11
Balance
Date Item P.R Debit Credit Debit Credit
2020
March 1 1 3500 00 3500 00

1 1 2400 00 1100 00

5 1 850 00 1950 00

6 1 125 00 1825 00

10 1 500 00 1325 00

13 1 575 00 750 00

16 1 1980 00 2730 00

20 1 650 00 2080 00

27 1 575 00 1505 00

31 1 69 00 1436 00

31 1 175 00 1261 00

31 1 1870 00 3131 00

31 1 1500 00 1631 00

2. Account Receivable Account No. 12

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 1 1 950 00 950 00

5 1 850 00 100 00

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 31 1 1675 00 1775 00

3. Account Supplies Account No.14

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 1 1 1200 00 1200 00

20 1 650 00 1850 00

4. Account Prepaid Rent Account No. 15

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 1 1 2400 00 2400 00

5. Account Photographic Equipment Account No. 18

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 1 1 15000 00 15000 00

4 1 2500 00 17500 00

6. Account accounts Payable Account No. 21

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 4 1 2500 00 2500 00

10 1 500 00 2000 00

7. Account Ann Hill Capital Account No.31

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 1 1 20650 00 20650 00

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 8. Account Ann Hill, Drawing Account No.32
Balance
Date Item P.R Debit Credit Debit Credit
2020
March 31 1 1500 00 1500 00

9. Account Sales Account No. 41

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 16 1 1980 00 1980 00

31 1 1870 00 3850 00

31 1 1675 00 5525 00

10. Account Salary Expense Account No.52

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 13 1 575 00 575 00

27 1 575 00 1150 00

11. Account Miscellaneous Expense Account No. 59

Balance
Date Item P.R Debit Credit Debit Credit
2020
March 6 1 125 00 125 00

31 1 69 00 194 00

31 1 175 00 369 00

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2.7 Trial Balance

The equality of debits and credits in the ledger should be verified at end of each
accounting period, such verification is called a trail balance.

A trial balance is a two column listing of the accounts in the ledger and their
balance to make sure that the total debit balances equals the total credit balances.
As the first step in preparing the trial balance, the balance of each account in the
ledger should be determined.

Hill Photographic Studio

Trial Balance
March 31,2020

Debit Credit
Cash 1631
Accounts Receivable 1775
Supplies 1850
Prepaid Rent 2400
Photographic Equipment 17500
Accounts payable 2000
Ann Hill, Capital 20650
Ann Hill, Drawing 1500
5525
Sales
Salary Expense 1150
Miscellaneous Expense 369

Total 28175 28175

Proof provided by trial Balance

The trial balance does not provide complete proof of the accuracy of the ledger. It
indicates only that the debits and the credits are equal. This proof is of value, however,
because most errors affect equality of debits and credits. If the two totals of a trial
balance are not equal it is probably due to one or more of the following types of errors:

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

a) One of the columns of the trial balance was incorrectly added.
b) The amount of an account balance was incorrectly recorded on the
trial balance.
c) A debit balance was recorded on a trial balance as a credit or vice-
versa, or a balance was omitted entirely.
2. Error in determining the account balances, such as:
a) A balance was incorrectly computed
b) A balance was entered in the wrong balance column.

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3. Errors in recording a transaction in the ledger, such as:
a) An erroneous amount was posted to the account
b) A debit entry was posted as a credit or vice versa
c) A debit or credit posting was omitted

Among the types of errors that will not cause an inequality in the trial balance totals are
the following:
1. Failure to record a transaction or to post a transaction
2. Recording the same erroneous amount for both debit and
credit part of a transaction
3. Recording a single transaction more than once

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