Fundamental Accounting I

Chapter Two
Accounting cycle for service-giving business
After studying this chapter, you should be able to:
- Explain the meaning and nature of an account.
- apply debits and credits to record business transactions
- Define the terms journal, ledger, journalizing, posting, trial balance etc.
- complete the accounting cycle
2.1 Introduction
In unit 1, you have learned the relationship between the accounting equation and business
transactions. Every business transaction affects the elements of the accounting equation.
This accounting procedure will be discussed in detail. The different and interrelated
stages of the accounting cycle will be presented. The chapter is lengthy, but essential for
the remaining chapters in this course and other accounting courses. Therefore, you are
advised to study the chapter carefully.

2.2 Nature of an account

In order to provide the necessary information to users, accountants maintain separate
records on each element of the financial statements. For example, to report the balance
for cash at the end of a year, a record regarding cash should be kept. The record includes
beginning cash balance, cash payments & cash collections during the period. This record
is called an account.
Definition: An account is a subdivision under the three elements of the accounting
equation used to record the changes over a single element in the financial statements. An
account has three parts, Title, Debit, and credit. For illustration purposes an account can
be represented in the form of capital letter ‘T’.
Example
Title
Debit Credit
Dr Cr

2.3 Classifications of Accounts

Accounts are classified into five: assets, liabilities, capital, and 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

CHAPTER 2 Accounting Cycle for Service-giving business Page 1

 Fundamental Accounting I

1. Assets: Resources owned by a business or individual are called assets. Assets could
be tangible or intangible. Tangible assets are assets having physical existence, like cash,
land, computer, stationery materials. Intangible assets do not have physical existence.
Example: Goodwill, Copyright, patent right.
On the balance sheet assets are classified into two current assets and non – current assets.
Current Assets – are those assets, which can be used, sold, or converted into cash within
one accounting year. 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.
2. Liabilities: Creditors’ claims to the assets of a business; amounts owed to creditors are
called liabilities. Like assets, liabilities are classified in to two as current liabilities and
non – current liabilities
Current liabilities: The liabilities that are payable within the next (one) accounting year
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. Example long term notes payable.
3. Capital: The excess of the assets of a business over its liabilities is referred to as
capital. It is the equity of the owner in the business.
4. Revenue: Are increases in owner’s equity resulting from the main operations of the
business.
Examples of revenue accounts are sales, interest income, tuition fee, and sales
commission.
5. Expenses: are decreases in owner’s equity in the process of earning revenue. For
example, a hotel has to pay salary to its workers for the services rendered to clients in
order to get the income form customers (revenue) the Hotel has pay salary to the
employees (expense).
Example of expenses: Salary, insurance, depreciation, supplies, utilities, rent etc.
2.4 Chart of Accounts
The number and name of accounts used by an organization depends on the nature of its
operation. The list of accounts used by an organization and their codes is called the chart
of accounts. Look at the following chart of accounts of Bati Transport.
Bati Transport
Chart of Accounts
Asset Account number

Cash--------------------------------------------------------------------------11

CHAPTER 2 Accounting Cycle for Service-giving business Page 2

 Fundamental Accounting I

Accounts Receivable------------------------------------------------------ 12
Supplies----------------------------------------------------------------------13
Prepaid Insurance----------------------------------------------------------14
Equipment-------------------------------------------------------------------15
Accumulated Depreciation –Equipment--------------------------------16
Truck-------------------------------------------------------------------------17
Accumulated depreciation – Truck--------------------------------------18

Liabilities
Accounts Payable-----------------------------------------------------------21
Notes Payable---------------------------------------------------------------22
Owners Equity
Yimer Adem, Capital--------------------------------------------------------31
Yimer Adem Drawing-------------------------------------------------------32
Income Summary------------------------------------------------------------33
Revenue
Service income---------------------------------------------------------------41
Expense
Salaries Expense -------------------------------------------------------------51
Rent Expense -----------------------------------------------------------------52
Utilities Expense--------------------------------------------------------------53
Supplies Expense-------------------------------------------------------------54
Insurance Expense-----------------------------------------------------------55
Maintenance Expense--------------------------------------------------------56
Depreciation Expense--------------------------------------------------------57
Truck Expense-----------------------------------------------------------------58
Miscellaneous expense-------------------------------------------------------59
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. Accounts other than cash will be listed in their frequency
of use or in alphabetical order.
The account number is a code to identify accounts. The number could be a two digit,
three digit or more digits. In the above example a three – digits code is used. When the
chart of accounts is prepared in an organization we say the ledger is opened.

2.5. Rules of Debits and Credits

As shown above every account has three parts. These parts are discussed below:
Title – The name of the account. This is written at the top of the account.

CHAPTER 2 Accounting Cycle for Service-giving business Page 3

 Fundamental Accounting I

Debit – is the left hand side of an account –Debit is abbreviated as ‘Dr.’. When an
amount is entered on the left side of an account we say the account is debited or
charged.
Credit – is the right hand side of an account. Credit is abbreviated as Cr. An account is
said to be credited when an amount is entered on the right hand side of the account.
An account may increase or decrease on the debit side or on the credit side depending on
the nature of the account. In general, accounts appearing on the left hand side of the
accounting equation increase on their left side (Dr. side) and decrease on their right side
(Cr. Side); whereas accounts on the right side of the equation increase on their right side
and decrease on their left side.
The above general rule will be expanded as follows
Debit Credit
-Increase in assets -Decrease in assets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in Liabilities
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.

The normal balance of an Account

Normal balance refers to the side of an account (Dr. or Cr.), which will have greater
entries than the other. The increasing side will be the normal balance for accounts.
Example: The normal balance of all asset accounts is debit.

2.6 Journalizing Business 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.
The Journal commonly used to record all types of transactions is the General Journal.
This Journal includes the following parts, entered step by step.
1. The date of the transaction
2. The title of the account debited
3. The title of the account credited
4. The amount of debit and credit
5. Brief explanation of the entry or reference to the source document.

CHAPTER 2 Accounting Cycle for Service-giving business Page 4

 Fundamental Accounting I

Look at the following General Journal and notice where each of the above information is
found.
General Journal page
Date Description P.R Debit Credit
Year
Month da Debited account title XX X
y X X
Credited account title X XX XX
Explanation

There are also other types of Journals like, known as special journals that are used to
record specific types of transactions. The cash Journal, for instance, is used to record
only transactions affecting cash. The General Journal is used for illustrations in this
chapter. Special journals are discussed in chapter 5.

Steps in Journalizing a Transaction

The following steps should be followed in recording a transaction in the journal.
1. Record the date - Insert the year, the month, and the date as shown above.
2. Record the Debit- Insert the account debited in the description column and the
amount of debit in the debit column.
3. Record the credit- Insert the account credited below the debited account and
indented to the right in the description column and the amount of credit in the
credit column.
4. Explanation- Write a brief explanation or reference to source document in the
description column, when necessary.

Each one set of debits and credits for a transaction is called a journal entry.
In recording a business transaction answer the following questions based on the
transaction to be recorded may help you.

a) Which accounts are affected?

b) Is each account increased or decreased?
c) Which account is debited and which is credited?
d) Prepare the complete journal entry.

CHAPTER 2 Accounting Cycle for Service-giving business Page 5

 Fundamental Accounting I

Example. On January 10, 2003 Tamget P.L.C paid Birr 6,000 to its employees as a salary
for the first week of the year.
This business transaction will be analyzed and recorded as follows.
a) Which accounts are affected? Answer: Cash and Salary Expense.
b) Is each account increased or decreased? Answer: cash is decreased and salary
expense is increased.
c) Which account is debited and which is credited? Answer: Salary Expense is debited
because increase in expenses is recorded on the debit side. And cash is credited
because decrease in assets is recorded on the debit side.
d) Prepare the complete Journal entry.

2003 Description
Jan. 10 Salary expense 6000 00
Cash 6000 00
Payment of salary

Note: A journal entry is the complete presentation of the record in the journal.
Exercise - 1
Journalize the following transaction by answering 4 questions suggested above.
 On January 11, 2003 Tamget bought a building for Birr 150,000 on credit.
Illustration
To illustrate the complete accounting cycle, we will consider the following list of
selected transactions. The transactions were completed by Bati Transport in the month of
January 2003.
January 1. Ato yimer took Birr 450,000 from his personal savings and deposited it in the
name of Bati transport.
January 2. Bati Transport purchased two used trucks for Birr 150,000 each, on cash.
January 4. Bati Transport received a check for Birr 650 for services given to Alem
Trading.
January 4. Received an invoice for truck expenses Birr 90.
January 11.Paid Birr 600 for Awash Insurance Company to buy an insurance policy for
its trucks.
January 16. Ato Yimer issued a check for Birr 9,400 to the workers as a salary for
two weeks.

CHAPTER 2 Accounting Cycle for Service-giving business Page 6

 Fundamental Accounting I

January 20. Bati trading Billed Muradu Supermarket for goods transported from
Djibouti to Gondar Birr 2,650
January 21. Ato Yimer wrote a check for birr 450 to have one of the trucks repainted
January 21. Bati trading purchased stationary materials and other supplies of Birr 740 on
account
January 22. Office equipment of Birr 11,600 is bought on account.
January 23. Purchased an additional truck for Birr 250,000 paying birr 100,000 in cash
and issuing a note for the difference.
January 23. Recorded services billed to customers on account birr 14,600.
January 25. Received cash from customers on account Birr 15,000.
January 27. The owner withdrew Birr 500 in cash for his personal use.
January 28. Paid Birr 9,400 to workers as a salary for the last two weeks of the month.
January 30. Paid telephone expense of Birr 95 and electric expenses of Birr 125 for the
month.
January 30. Paid other miscellaneous expenses Birr 50.
January 31. Paid Birr 4,000 as a rent for a building used for office space.

These transactions are journalized as follows:

2.7 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 called posting.
posting.

An account could be of two types; the two-column account and the four-column
account. We will use the four-column account for our illustration. The two forms of
accounts are given below.
The two-column account:
Account title Account number______
Date Item P.R Debit Date Item P. Credit
R

The four-column account:

Account title Account number_________
number_________

CHAPTER 2 Accounting Cycle for Service-giving business Page 7

 Fundamental Accounting I

Date Item P.R Debit Credit Balance

Debit Credit

The steps in posting are given below:

1. Record the date and amount of Dr. and Cr. Entry to the account
2. Insert the Journal page number in the P.R (Post Reference) column of the
account.
3. Insert the account number in the P.R column of the journal.
Note. The P.R Column is used for reference purposes. The P.R column of the journal
shows whether the entry is posted and the account to which it is posted. In the
account, the P.R Column shows the Journal page number from which the entry was
brought.
The group of accounts used by an organization is called ledger.
ledger.
Illustration.
Illustration. As mentioned above, to illustrate the posting process the four column
account is used and the entries to the cash account are posted as follows.
Account Cash Account Number ______
Balance
Date Item P.R Debit Credit Debit Credit
2003 450,000 00 450,000 00
Jan 1
2 300,000 00 150,000 00
4 650 00 150,650 00
11 600 00 150,050 00
16 9,400 00 140,650 00
21 450 00 140,200 00
23 100,000 00 40,200 00
25 15,000 00 55,200 00
27 500 00 54,200 00
28 9,400 00 45,300 00
30 220 00 45,080 00
30 50 00 45,030 00
31 4,000 00 41,030 00
Note.
Note. The item column is usually left blank. In some cases the word balance is
written when the account is carried forward to a new page.

CHAPTER 2 Accounting Cycle for Service-giving business Page 8

 Fundamental Accounting I

2.8 The Trial Balance

After the posting phase is completed, we have to verify the equality of the debit and
credit balances. This is done through the use of the ‘Trial Balance’. A trial balance is
a two column listing of the accounts in the ledger and their balance to make sure
that the total of debit balances equals the total of credit balances.

The trial balance for our illustration, Bati Transport is presented bellow. The
amounts are taken from the balances of the accounts after all the transactions have
been posted. Therefore, after posting the above transactions, you should get the
final balances shown on the trial balance in the end.
Bati Transport
Trial Balance
January 31, 2003

Cash 41,030 00
Accounts Receivable 2,250 00
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 11,600 00
Truck 550,000 00
Accounts payable 12,430 00
Notes payable 150,000 00
Yimer capital 450,000 00
Yimer drawing 500 00
Service income 17,900 00
Salary expense 18,800 00
Rent expense 4,000 00
Utilities expense 220 00
Maintenance expense 450 00
Truck expense 90 00
Miscellaneous expense 50 00
Total 630,330 00 630,330 00

2.8.1 Proof Provided by the Trial Balance

The trial balance debit totals and credit totals are equal implies that the accounting
work is more likely to be free from any one or more of the following errors.

1. Error in preparing the trial balance including

-Addition error

CHAPTER 2 Accounting Cycle for Service-giving business Page 9

 Fundamental Accounting I

-The amount of an account balance was in correctly listed on the trial

balance
- A debit balance was recorded as a credit or vice versa
- A balance was entirely omitted.
2. Error in posting, including
- An erroneous amount was posted to the account.
- A debit amount was posted as a credit or vice versa
- A debit or credit posting was omitted

2.8.2 Limitations of the Trial Balance

The trial balance amounts are equal doesn’t mean that the accounting work is free
from error. That is, there are errors that may take place without affecting the trial
balance totals. Some examples are mentioned below:
- Failure to record a transaction or to post a transaction
- Recording the same erroneous amount for both the debit and the credit
parts of a transaction.
- Recording the same transaction more than once.
- Posting part of a transaction to the correct side but the wrong account.
Note: All these errors have the same affect (increasing or decreasing) on the debit
totals and credit totals

2.9 Adjustments

All the transactions recorded above in the journalizing step are the result of daily
transactions. Other transactions result from the passage of time or from the internal
operations of the business. For example, insurance premiums are paid for a certain
period of time and expire during that time period. Another example is office
supplies such as paper, pens & pencils.
At the end of the period the balances in accounts such as supplies and prepaid
insurance must be brought up to date. The supplies account balance, for example,
must be credited by the consumed part of the supplies, debiting supplies expense .

Example. Stationary materials totaling Birr 1,900.00 were purchased and recorded
during the year. At the end of the year, only Birr 150 of the supplies are left in hand.
The adjusting entry prepared at the end of the year to adjust the supplies account
will be
1990 Supplies expense 1,750

CHAPTER 2 Accounting Cycle for Service-giving business Page 10

 Fundamental Accounting I

Dec31 Supplies 1,750

Note: 1. Adjustments are dated as the last day of the year.

2. The accounting year here – we assume, runs from January 1- December 31
Additional examples on adjustments will be given below under the topic ‘worksheet’
2.9.1 The Accrual Basis and the Cash Basis of Accounting
1. The cash basis of accounting – In this basis of accounting revenues are reported
in the period in which cash is received and expenses are reported in the period in
which cash is paid. Net income will, therefore, be the difference between the cash
receipts (Revenues) and cash payments (expenses). This method will be used by
organizations that have very few receivables and payables. For most
2. Businesses, however, the cash basis are not an acceptable method.
3. The accrual basis of accounting – Under this method revenues are reported in
the period in which they are earned, and expenses are reported in the period in which
they are incurred. For example, revenue will be recognized as services are provided
to customers or goods sold and not when cash is collected. Most organizations use
this method of accounting and we will apply this method in this course.
2.9.2 The Matching Principle
We have discussed three concepts and principles in accounting in unit one. Now we
will see one more principle, the matching principle. This principle states that the
expense of a period have to be matched with the revenue of that period regardless
of when payment is made. In order to do this, the accrual basis of accounting
requires the use of an adjusting process at the end of the period so that revenues
and expenses of the period will be determined properly.

2.10 Worksheet for Financial Statements

Most of the data required to prepare the accounting reports (financial statements) is
now gathered. The data will now be presented in a convenient form. The
worksheet is a large columnar sheet prepared to arrange in a convenient form all
the accounting data required to prepare financial statements. The worksheet has a
heading and a body.
The heading has three parts:
i) Name of the Organization
ii) Name of the form (worksheet)

CHAPTER 2 Accounting Cycle for Service-giving business Page 11

 Fundamental Accounting I

iii) Period of time covered.

The body contains five main parts each of them with two main columns. These
parts are
1. The trial balance
2. The adjustment
3. The adjusted trial balance
4. The income statement
5. The balance sheet.
1. The trial balance column – this is the same trial balance we have prepared
before. The trial balance column of the work sheet can be brought direct from the
ledger or from a separate trial balance.

2. The Adjustment column – As mentioned previously, some account balances

have to be adjusted at the end of the year.
The accounts in the ledger of our illustration that require adjustment and the
adjusting entry for the accounts are presented below.
a) Supplies – The supplies account has a debit balance of Birr 740. The cost of
supplies in hand on July 31 is determined to be Birr 400. The following adjusting
entry is required to bring the balance of the account up to date:

Supplies expense…………………………….340
Supplies……………………………………..340
b) Prepaid insurance – Analysis of the policy showed that three – fourth of the
policy is expired. That is only Birr 150 of the policy is applicable to future periods.
The adjusting entry to transfer the expired part of the insurance to expense will be.
Insurance expense ……………………….450
Prepaid insurance………………………..450
c) Service Income – At the end of the month unbilled fees for services performed
to clients totaled Birr 6,500.
This amount refers to an income earned but to be collected in the future. The
journal entry to record it will be
Accounts receivable………………………….6,500
Service income………………………………6,500
All the above adjusting entries will be inserted in the adjustment column of the
worksheet in front of the accounts affected.

CHAPTER 2 Accounting Cycle for Service-giving business Page 12

 Fundamental Accounting I

Note – The letters a, b & c are used to cross-reference the debits and credits to help
future review of the worksheet.
3. The Adjusted Trial Balance Column – The accounts that require adjustment
are now adjusted. Transferring the trial balance column amounts combined with
the adjustment column amounts will complete the adjusted trial balance column of
the worksheet.
4. The income statement and the balance sheet columns – Transfer the income
statement account balances (revenue &expenses) to the income statement and
balance sheet account balances (Asset, Liability &owners equity) to the balance
sheet columns. Note that what we have to transfer is the adjusted trial balance
column amounts, to the corresponding columns.
Look at the 22nd row. It shows the net income for the month and it is added to the
two columns (Income statement Dr. and balance sheet cr.) as a balancing figure.
2.11 Financial statement preparation
After the work sheet is completed financial statements could be prepared easily. In
chapter one, we have discussed four basic financial statements prepared by most
organizations.
2.12 The closing process
Some of the accounts in the ledger are temporary accounts used to classify and
summarize the transactions affecting capital (owner’s equity). These accounts will
be closed after financial statements are prepared. That is, their balances will be
transferred to the Capital account. The temporary accounts that have to be closed
are revenue, expense and withdrawal accounts.
Steps in closing:
1. Closing revenue accounts - Debit each revenue account by its balance and credit
the ‘Income Summary’ account by the total revenue for the period.
Note: Income summary is an account used to close revenue and expense
accounts. This account will immediately be closed to the capital account at the
end of the closing process.
2. Closing expense accounts – Debit the income summary account by the total of
expenses for the period and credit each expense account by its balance.
3. Closing the income summary account – Income summary will be closed to the
capital account. The balance of his account depends on the nature of operation;
credit if result is profit and debit if result is loss.
4. Closing Withdrawal – Debit the owners equity account by the total of drawings
for the period and credit the drawing account.

CHAPTER 2 Accounting Cycle for Service-giving business Page 13

 Fundamental Accounting I

2.13 Post closing trial Balance

After the closing entries have been journalized and posted, a trial balance is
prepared to prove the equality of the general ledger before recording the New Year’s
transactions. It should be noted that this trial balance includes only balance sheet
accounts. This is because the temporary income statement accounts are closed
during the closing process. This trial balance is called the post – closing trial
balance.
balance.
2.14 Summary

Accountants go through a number of step-by-step procedures to record transactions

and to summarize the records in to useful reports in a systematic manner. These
procedures that accountants go through from the time a transaction is identified
until the time financial statements are prepared are together called the accounting
cycle.

CHAPTER 2 Accounting Cycle for Service-giving business Page 14