CHAPTER ONE: INTRODUCTION TO ACCOUNTING AND BUSINESS

The Nature of Accounting

Accounting: is the process of collecting, analyzing, recording, summarizing, and interpreting
financial activities to permit individuals and organization to make informed judgments and
decisions.
 Collecting: gathering relevant source documents
 Analyzing: examining these reports by breaking them down in order to determine
financial success or failure.
 Recording: making written records of events
 Summarizing: the process of combining these written records
 Interpreting: involves the use of financial data to make sound decision.
Things we record in accounting are expressed in terms of money (monetary term).
The role of Accounting in business
Accounting is often called the “language of business”. This language can be viewed as an
information system that provides essential information about the financial activities of an entity
to various individuals or groups for their use in making informed judgments and decisions.
By law all businesses must keep accounting records. Decisions are based on accounting
information for both profit and not-for-profit companies. Private business—objective is to earn a
profit and to accumulate wealth.
Forms of Business Organizations
There are different forms of business organizations:
 Sole Proprietorship—owned by one person
 Partnership—co-owned by two or more persons(partners)
 Corporation—owned by many investors called stockholders (The business—not the
owners—are responsible for the company’s obligations.)
There are different types of business organizations:
 Service business: render/provide services to customers like doctors, lawyers, barber
shop, etc.
 Merchandising business—purchases goods for resale
 Manufacturing business—produces a product to sell
 Contractions – build capital facilities like real-estate, road bridge and etc

Bookkeeping Vs Accounting
Bookkeeping: Bookkeeping is only one branch of accounting that emphasis on record keeping
activities.
 Bookkeepers are persons working on record keeping activities in a prescribed manner.
 Bookkeepers are supervised by accountant.
 The work of bookkeeper can be replaced by computer.
Accounting: Accounting deals with designing (establishing) a record keeping system and review
the accounting records. The scope of accounting is much wider than that of bookkeeping.
Accountant is responsible to review the work of bookkeeper.

Principles and practices

Accounting principles are guide lines to be followed by the accountant when measuring and
recording financial activities of a firm. Accounting principles are derived from problems in
accounting practices.
Example; the problems in single entry accounting system is the reason for the double entry
accounting system investigation.

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Business entity concept (Economic Entity Concept)
This principle states that, every entirety in the world must have its own separate accounting
(recording) system. This means the business should be separate and distinct record from the
owner and other business.
Cost principle
The cost principle states that resource (assets) purchased by an enterprise should be recorded at
cost. Cost refers to the amount of money paid when acquiring an asset.
Unit of measurement principle
Accounting records only things (transactions) are expressed in terms of money. It does not
record things that are measured in other units of measurement like meter, kilogram, liter etc.
Eg. The death of the manager of a given organization may have some input on once
organization. Even if it is so, we can not express his/her death in terms of money.
Profession of Accountancy
In the profession of accounting there are two major fields. These are:
1. Private Accounting
2. Public Accounting
1. Private accounting: The accountant in the private accounting acts as employees of the
organization .The organization can be governmental, NGOs, private business organizations
etc.
The accountant here helps in preparing financial information to the management of the
organization and financial statement to the external users. They are dependent on the
management of the organization and work on salary bases.
2. Public Accounting: Here accountant acts independently and work on fee bases.
Example; Certified Public Accountant (CPA), Certified Management Accountant(CMA) -
Once an accountant receives his/her CPA he/she can work on the following areas:
 Auditing
 Management Advisory service
 Designing an accounting system.

Users of accounting information

Interested parties are also called accounting information users. There are two broad categories of
accounting information users:
 internal users
 external users
Internal users:
Internal users are parties inside the reporting entity (company) who are interested in the
accounting information.
Internal users are those individuals directly involved in managing and employees
operating an organization.

Example: managers-for controlling, monitoring and planning, officers, internal auditors, sales
managers, budget officer, other internal decision maker.
External users
External users are parties outside the reporting entity (company) who are interested in
the accounting information.
They are not directly involved in running the organization.
Examples:
 lenders(banks and financial companies)-whether an organization is likely to repay its loan
with interest and to grant loan
 shareholders(investors)-what is income for current and past periods-to assess the return
and risk in acquiring shares
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  External auditors-to examine and provide an opinion on whether financial statements are
prepared according to GAAP.
 Employees-to judge the fairness of their wages, to assess future jobs prospective.
 Regulators(internal revenue service, tax authorities)-to compute taxes
 Others such as:
Voters, Legislators, elected officials to monitor and evaluate a government
receipts and expenses.
Contributors to not for profit organization-to evaluate the use and impact of their
donations.
Suppliers – to judge the soundness of the business before making sales on credit.
Customers –to assess the staying power of suppliers.
The Elements of Financial Statement
1. Assets
Are items with money value that are owned by a business
An item has a dollar (birr) value to be recorded in accounting records.
Example: cash, accounts receivable, supplies, inventories, equipment, land
buildings etc
2. Liabilities:
Debts owed by the business-obligation of a business.
A liability that results from purchasing goods and services on credit is called
accounts payable. Other liabilities include notes payable, interest payable, wages
payable etc
3. Owner’s Equity:
The difference between what is owned and what is owed is owner’s equity.
It is the excess of assets over liabilities.
Also called capital, proprietorship, net worth, and net asset.
4. Revenues:
Revenues are increases in capital due to inflow of resources from business
operations such as, provision of services or sales of goods.
5. Expenses:
Expenses are decrease in capital due to outflow of resources for the purpose of
business operations.
6. Drawings: An owner may withdraw cash or other assets during the accounting period for
personal use. These withdrawals could be recorded as a direct decrease of owner’s equity
and recorded in drawings account.
Drawings decrease total owner’s equity.

Basic Accounting Equation

The relationship among the accounting elements can be expressed in a single mathematical form
known as the accounting equation or the basic accounting equation (balance sheet equation)
 Equities: are claims against the asset of a business.
Assets = Equities
Claims are divided into two categories:
 Creditors' claims that are called liabilities
 Owners' claims that are called equity
Assets = Liabilities + Owner’s Equity
A= L + OE
If a company goes bankrupt, liabilities are paid off first to creditors, while owner’s equity is the
last to be distributed. Therefore, owners' equity is also called residual equity.
The following diagram depicts how the capital of a firm can be affected.

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Additional Investments Revenues
Increase capital

Capital

Withdrawal Decrease Capital Expenses

Business Transactions and Accounting Equation
Any activity that changes the value of assets, liabilities, owner’s equity, revenue
or expenses is called transaction
Business transaction is an exchange of economic consideration between two parties/event of
occurrence or condition that must be recorded.
E.g. hiring an employee does not change the value of any assets, liabilities and owner’s equity,
so it is not a transaction.

Transaction can be created internally or external.

Internal transaction: internally created
E.g. Salary payment, Depreciation, Supplies, Allowance for uncollectible
External transaction: transaction related to outsiders
Example: purchase of asset on account, cash payment to a creditor, receipt of cash for service
rendered, payment of rent and collection of accounts receivable

ILLUSTRATION
Recording the effect of transactions on the accounting Equation for the Month ended December
31,2010
a) Alex the owner of Alex Barber invested Br. 10,000 cash in the business
b) Invested supplies valued at Birr 2000 in the business.
c) Paid rent for the month Birr 600.
d) Performed service and received cash Br 800.
e) Purchased supplies on credit Br 200.
f) Preformed service on credit, Br 625
g) Withdrew cash for personal use Br 500.
h) Received Br 250 cash as partial payment for service performed on account

Assets Liabilities + Owners’ Equity Description

Cash + Account + Supplies = Account + Alex,
Receivable Payable Capital
a. Br.10,000 Br10,000 Investment

b. 2,000 2,000 Investment

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 c. (600) (600) Rent expense

d. 800 800 Revenue

e. 200 200 Liability

f. 625 625 Revenue

g. (500) (500) Withdrawal

h. 250 (250)

Total 9,950 + 375 + 2,200 = 200 + 12,325

Total Dr. Br12,525 Total Cr. Br12,525

Assets Liabilities + Owners’ Equity Description

Cash +
Financial Statements
 Financial statements are summaries of financial activities of an enterprise.
 Financial statements are prepared at the end of an accounting period
 Financial statements are prepared from business transitions.
 Financial statements are output of accounting system
Time Period (Periodicity) concept: the economic life of a business should be divided in to
artificial period of time. Analysis of Financial condition and preparation of financial statements
is done at regular intervals.
The length of time for which an analysis of business operations is done is called a
Fiscal Period or Accounting period.
Fiscal period/accounting period may consist either of: a month usually minimum, a
quarter, semiannual, a year –usually maximum length.
The accounting time period of one year in length is usually known as a
fiscal year.
The four major financial statements are:
1. Income statement:
Describes a company’s revenues and expenses along with the resulting net income or
net loss over a period of time.
An income statement is also called Statement of Operations, Earnings Statement,
or Profit and Loss Statement (P/L).
When revenue exceeds expenses, there is a net income.
When expenses exceed revenue, there is a net loss.
2. Statement of Owner’s equity:
Explains changes in equity due to items such as net income, net loss, owner’s
investment, and owner’s withdrawal over a period of time.
Expenses & owner’s withdrawal decreases the Owners equity of a business.
Revenues & owner’s investment increases the Owners equity of a business.
Preparation of owners’ equity statement is optional.
3. Balance sheet:
 A listing of a firm’s assets, liabilities and owner’s equity at a specific date.
 A balance sheet is also called Statement of Financial Position.
There are two forms of balance sheet:
 An account form balance sheet.

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  A report form balance sheet

The body of account form balance sheet has two sides: a left-hand side and a right-hand side.
The assets of a business are listed on the left-hand side of the balance sheet. The liabilities and
capital are listed on the right-hand side of the balance sheet.

Account form Balance Sheet (Two sides of balance sheet)

Left-hand side Right-hand side

A) ASSETS B) LIABILITIES
(What is owned?) (What is owed?)
C) CAPITAL
(What the businesses worth)

TOTAL ASSETS Total LIABILITIES + CAPITAL

In report form of balance sheet, all items—assets, liabilities, and capital—are listed down in the
order shown below:
Report form balance sheet

Account Titles
Amounts
Assets
xx Total Assets
xxLiabilities
xxCapital
xx Total Liabilities & Capital
xx
4. Statement of cash flows: identifies cash inflows and outflows over a period of time.
There are 3 types of cash flows (CF): 
 Cash flow from operating activities – cash flow generated by normal business operations
 Cash flow from investing activities – cash flow from buying and selling assets: buildings,
real estate, investment portfolios, equipment.
 Cash flow from financing activities – cash flow from investors or long-term creditors

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The Following is Summary of Financial Statements

- Statement of Operations or
Income Statement - Earnings Statement or,
- Earnings Statement or,
- Profit and Loss Statement

- Statement of Capital
Statement of Owner’s equity - Statement of net worth
Financial statements

- Account form balance sheet

Balance sheet - Report form balance sheet
(Statement of position)
- Cash flow from operating activities
- Cash flow from investing
activities
Statement of cash flows -Cash flow from financing
activities
See the following financial statements prepared for Alex Barber, service business from the above
transactions.

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CHAPTER TWO: THE ACCOUNTING CYCLE FOR A SERVICE
BUSINES

2.1. Classification of Accounts

Accounting Cycle - sequence of procedures used to record, classify and summarize accounting
information in financial reports, on a regular basis.
Account: An accounting form that is used to record the changes caused by business
transactions.
The accounting cycle usually starts from occurrence of business transactions
 After business documents were prepared it should be recorded in a journal- Recording
(Journalizing)
 Then we post it to the ledger accounts- classification
 In order to check our record in a journal and posting in ledgers, we need to use trail
balance- summary
 Then financial statement is prepared- reporting,
 Closing temporary account follows - year end procedure , and
 Finally post close trail balance is prepared -year end procedure.
There are 5 types of Accounts (Classification of Accounts):
1) Assets
2) Liabilities
3) Owners' Equity (Stockholders' Equity for a corporation)
4) Revenues
5) Expenses
1. Assets: any physical thing (tangible) or right (intangible) that has a value is an asset.
 Current asset: asset that may reasonably be expected to be realized in cash or sold
or used up usually within one year or less.
Example: cash, account receivable, supplies, inventory, short term notes receivable.
 Plant assets (fixed assets) tangible asset used in the business that are of a
permanent or relatively fixed nature. Fixed assets include: equipment, machinery,
buildings, and land.
2. Liabilities: debts owed to outsiders (creditors)
 Current liabilities: liabilities due within a short time (usually one year or less) and
that are to be paid out of current assets.
Example: account payable, short note payable, salaries payable, interest payable, tax
payable, unearned revenue.
 Long term liability: liability that will not be due for a comparatively long time
(usually more than one year) or company’s obligations not expected to be paid
within one year (or a longer operating cycle). Example: long term notes payable,
bonds payable, lease liabilities.
3. Owner’s equity: residual claim against the business asset after the total liabilities are
deducted.
4. Revenues: gross increase in owner’s equity as a result of the sale of merchandize,
performance of service to customer, rental of property, lending of money, and other business
and professional activities.
5. Expenses: costs that have been consumed in the process of producing revenue are expired
costs or expenses.
Drawings: drawings represent the amount of withdrawals made by the owner of business.
Standard form of account has three major parts:
1. The account title and number
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 2. The left side, which is called the debit side
3. The right side, which is called the credit side.
There are two forms of accounts:
1. Two amount columns account and
2. Four amount column account.
Two amount column account:
Account Title: Account No.:
Date Item Post Debit Date Item Post Credit
Ref. Ref.

Four-amount column account:

Account Title: Account No.:
Date Item Post. Ref. Debit Credit Balance
Debit Credit

The following advantages of the four-column account as compared with the two-column are:
The four-column account:
1) provides an easy means of analyzing and examining the accounts,
2) presents transactions in their chronological order of occurrence as the journal does,
facilitating easy location,
3) uses only one date column, saving space and time required for analysis, and
4) Makes balance of an account always available after each transaction is transferred to the
account.
Accounts are often grouped together in a book form; such a grouping of accounts is called a
ledger. Thus, accounts are frequently referred to as ledger accounts. A skeleton version of a
standard form of account, used for ease analysis of account balance is called T account.
The T account has three parts:
1. The account title
2. Space for recording increases in the amount of the item, and
3. Space for recording decreases in the amount of the item
Title of account
Left Side Right side
(Debit side) (Credit side)
 The left side of any account is the debit side and the right side is called the credit side.
Chart of Accounts
 A list of accounts in the ledger.
 outline the order of accounts in the ledger
 directory of accounts available in the ledger

Sample Chart of accounts

Assets
11 Cash
12 Accounts receivable
13 Supplies
16 Office equipment
17 Office furniture
Liabilities
21 Accounts payable
22 Salaries payable
Owner’s equity
31 Capitals

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 32 Drawing
Revenue
41 Service revenue
Expenses
51 Rent expense
52 Supplies expense
53 Repairs
54 Expense
 The first digit of account number indicates major division of the ledger in which
account is placed.
 A second digit of account number indicates position of account with in its division
2.2. Rules of Debit and Credit
Depending on the nature of account affected debit or credit may be either decrease or increase.
 Debit can signify either increase or decrease
 Credit can signify either increase or decrease

Debit and Credit rules of accounts:

Account Increase side Decrease side Normal Balance
Any Asset Debit Credit Debit
Any Liability Credit Debit Credit
Owner’s equity (Capital) Credit Debit Credit
Any Revenue Credit Debit Credit
Any Expense Debit Credit Debit
Owner’s drawing Debit Credit Debit
Balance of an account: account balance is the difference between the increase and decrease
recorded in an account. The normal balance of all accounts are positive rather than negative
because the sum of the increases recorded in an account is usually equal to or greater than the
sum of the decreases recorded in the account.

Journal:
 Is the book in which the records of business are written.
 It is a chronological record of events.
General journal:
 Is the original book of entry
 Information recorded on this book is usually extracted from the source documents such as
invoices, receipts, contracts agreements and many other relevant documents.
 It would usually show the account to be debited and credited and short description on the
transaction.
 Information on this book will be posted to the ledger.
 General journal is used to record all kinds of entries
Forms of the Two Column Journal
General Journal Page No. _______
Date Account Title (Description) P/R Debit Credit

Special Journals:
 A journal in which only one kind of business transaction is recorded is a special journal
used to record only one type of entries.
 Special journals differ from the general journal or the combination journal in that they are
meant only for specified types of transactions—only one type. These include:
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 1. Sales journal: Sales journal is a special journal used to record only sales of
merchandized on account.
2. Purchase journal: used to record purchase on account
3. Cash receipt journal: use to record cash receipt (cash collection)
4. Cash payment journal: used to record payment of cash.
5. Combination Journal: is a multi-column journal that combines all journals into one
book of original entry.
Companies may use various kinds of journals, but every company has the most basic form of
journal, a general journal. Typically, a general journal has; spaces for dates, account titles and
explanations, references, and two amount columns.
The format of two amount column journal takes the following:

2.3. Recording Business Transactions

Journalizing: it is the process if entering transaction data in the journal.
Entry – entry refers to each record in a journal
The process of recording a transaction in a two column journal involves:
1. Record the date(year, month, and date)
2. Record the debit part(title of account and amount)
3. Record the credit part(title of account and amount)
4. Write an explanation in the description column.
General Journal Page 1
Date Account Title Post. Debit Credit
Ref.
xx x Record the debit part xx
Record the credit part xx
(Explanation)

Step 1 Step 2 Step 3 Step 4

To illustrate, assume that Wisdom Company incurred the following transactions during April
2011:
Transactions:
1. Mr. Wisdom invested Br.10, 000 cash in to his business to get it started.
2. Purchased office equipment for Br3,000 on account
3. Purchased office supplies for cash Br125
4. Paid Br500 on equipment purchased in transaction(2)
5. Paid first month rent Br400
6. Paid for repairs to equipment Br50
7. Received cash from customer for services Br1,800
8. Performed services on account Br400
9. Mr. Wisdom withdrew Br800 cash from the business for personal use.
10. Collected Br100 cash on account from credit customers in transaction(8)
Required: Record the above transactions in a general journal.

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GENERAL JOURNAL
Date Account Titles and Explanation P/R. Debit Credit
2011
April. 1 Cash 10,000
Wisdom, Capital 10,000
(invested cash in business)
2 Office Equipment 7,000
Account payable 7,000
(purchased equipment on account)
3 Office supplies 125
Cash 125
(purchased equipment for cash)
4 Account payable 500
Cash 500
(payment of on account)
5 Rent expense 400
Cash 400
(paid cash for rent)
6 Repairs expense 50
Cash 50
(Paid cash for repair)
7 Cash 1,800
Service revenue 1,800
(collection of on account)
8 Account receivable 400
Service revenue 400
(service rendered on credit)
9 Wisdom, Drawing 800
Cash 800
( cash withdrawn by the owner)
10 Cash 100 The
Account receivable 100 procedure
(collection of credit) of
transferring journal entries to the ledger accounts is called posting.
Advantages of Posting:
General ledger is the main book of accounts. This is the book where all the accounts are kept.
Each account maintained in this book will contain specifically information that relates to that
particular item alone. Information will generally be from the journal.
Ledger:
o Ledger is a collection of accounts together in one book
o Ledger is a group of accounts in a book. Because the information recorded in the ledger
originates from the journal, a ledger is also known as a book of secondary entry.
o A ledger that contains all the accounts needed to prepare the income statement and the
balance sheet is called a general ledger.
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 o An account in the general ledger that summarizes all the accounts in the subsidiary ledger
is called a controlling account.
o A ledger that is summarized into and controlled by a single account in the general ledger
is called a subsidiary ledger.
o A single account in the subsidiary ledger is known as a subsidiary account.

Posting entries from journal to accounts in the ledger.

When posting a debit and a credit entry, you just follow five steps:
Step 1 Write the amount in the debit column or in the credit column of the account in the
ledger.
Step 2 Take the account balance of the debit column or credit column of the balance to
the balance column of the account.
Step 3 Write the date of the journal entry in the Date column of the ledger (account).
Step 4 Write the Journal page number in the posting reference column of the account.
Step 5 Come back to the journal and write in the P/R column of the journal, the account
number of the ledger (account)
To illustrate let’s see how to post transaction number 1 in the above illustration. Assume that
the cash account has a balance of Br.20, 000 before the transaction 1.

Account Title _Cash Account No 11

Date Item Post. Debit Credit Debit
Ref. Balance
2011
April. 1 Balance  20,000 00

1 1 10,000 00 30,000 00

Step 3








Step 4 Step 1 Step 2
 Step number 5 is taking back the account number, 11, into the Posting Reference column of
the journal in the same line as the transaction.
The Trial Balance: A trial balance is a list of accounts and their balances at a given time. It is
tools used to check the equality of total debits and total credit balances of ledgers
Customarily, a trial balance is prepared at the end of an accounting period.
Trial Balance is:
A list of accounts and their balances at a point in time.
Used to prove the equality of debit and credit amount in the ledger.
Does not provide complete proof of the accuracy of ledger.
The primary purpose of a trial balance is to prove the mathematical equality of
debits and credits after posting.
A trial balance also uncovers errors in journalizing and posting. In addition, it is
useful in the preparation of financial statements.
The procedures for preparing a trial balance consist of:
1. Listing the account titles and their balances.
2. Totaling the debit and credit columns.
3. Proving the equality of the two columns

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 Wisdom Company
Trial Balance
April 30,2011
Account title Account Debit Credit
number
Cash 11 10,025
Account receivable 12 300
Supplies 13 125
Equipment 16 3,000
Errors are of two
Account payable 21 2,500
types:
Wisdom, Capital 31 10,000
Wisdom, Drawing 32 800 1. Errors
Service revenue 41 2,200
Rent expense 51 400
Repair expense 53 50
Total 14,700 14,700
committed before posting
2. Errors committed after posting

1. If errors are committed before posting (in journal) it can be corrected by ruling a straight
line through the incorrect part( Name or amount) and writing the correct name/amount
immediately above the incorrect one.

Example: Assume that purchase of equipment on account for Br 20,000 was wrongly
credited to cash account on May 15, 2010.
General Journal Page No. _20______
Date Account Title (Description) P/R Debit Credit
2010 15 Equipment 20,000
May
Account payable
Cash 20,000

1.1. Types of Adjusting Entries

The number of adjustments needed at the end of each accounting period depends
entirely upon the nature of the company’s business activities. However, most
adjusting entries fall in to one of the four general categories:
1. Converting assets to expenses
2. Converting liabilities to revenue
3. Accruing unpaid expenses, and
4. Accruing uncollected revenue
Deferral adjustments are of two types:
1. Prepaid expense (Assets/expense) adjustments
 Transfer amounts from asset accounts to expense accounts
2. Unearned revenue (deferred Revenue) Liability/revenue adjustments
 Transferring amounts from liability to revenue accounts.

Converting assets to Expenses /Prepaid Expense Adjustments:

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 Prepaid expenses are expenses paid in cash and recorded as assets before they are
used or consumed. Prepaid expenses expire with the passage of time or through use
and consumption.
Example 1: Assume that on November 15, the dental office paid Br 1, 800 for six
months of insurance coverage (from November 15 to May 15 of next year). This
results in Br300 coverage each full month. By December 31 (the end of the

fiscalperiod), the dentist will have received one and one-half months of coverage
(Br 450). Therefore, the following entry would be necessary:
Therefore on November 15, the following entry is made:

Date Accounts Debit Credit

2008  
Nov. 15 Prepaid insurance expense 1800.00
       Cash   1800.00
On November 15, the amount paid represents future benefits (insurance coverage)
to the dental office. The adjusting entry is to debit Insurance Expense and credit
Prepaid Insurance. On December 31, the following adjusting entry is prepared:
Date Accounts Debit Credit
2008  
Dec. 31 Insurance Expense 450.00
       Prepaid Insurance   450.00
Example 2: Assume that Gonzalez Company purchased Br 1,000 of supplies and
debits Office Supplies during the year 2008. The beginning balance of the Office
Supplies account was Br 200. At Dec. 31 2008, Br 300 of supplies was on hand. The
adjusting entry would, therefore, be:
Date Accounts Debit Credit
2008  
Dec. 31 Supplies expense 900.00
       Supplies   900.00
EXERCISE:
Assume that XYZ Company paid Br.3,600 on January, 1, 2010 for insurance coverage
for the following three years.
Required:
a) Show the journal entry made on January 1 and
b) Show the adjusting entry to be made on December 31,2010
Converting liabilities to Revenue (Unearned Revenue) Adjustments:
These are cash received before providing products or services. The cash received is
debited against the liability account when it is received. Revenues are recorded
when the work is done. So, we owe the work - it’s a liability. At the end of the
period, we reduce the liability to reflect the portion of the work that has been done
(this increases a revenue account).
 Unearned revenues are revenues received and recorded as liabilities before
they are earned.
 Unearned revenues are subsequently earned by rendering service to a
customer.
 A liability-revenue account relationship exists with unearned revenues.
 Prior to adjustment, liabilities are overstated and revenues are understated.
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  The adjusting entry results in a debit to a liability account and a credit to a
revenue account.
Example: Assume that on December 1, the dental office accepted a Br 2,400
payment from local businesses to provide dental care to their employees over the
next three months. The initial entry on December 1 would be as follows:

Date Accounts Debit Credit

2008  
Dec. 1 Cash 2400.00
       Unearned Dental Fees   2400.00

Example: Accrued salaries: Some types of expenses, such as employee salaries and
commissions, are paid for after the services have been performed. Assume that at Wisdom
Service Company, salaries were last paid on October 26 (Friday); the next payment of salaries
will not occur until November 9 (Friday). Three working days remain in October (October 29-
31).
At October 31, the salaries for these days represent an accrued expense and related liability to
Wisdom Company. The employees receive total salaries of Br.2,000 for a five-day workweek, or
Br.400 per day. Thus, accrued salaries at October 31 are Br.1,200 ( Br. 400 x 3), and the
adjusting entry is:
Oct. 31 Salaries expense 1,200
Salaries payable 1,200
(To record accrued salaries )

Depreciation: 

A portion of their cost is simply allocated to each accounting period. 

This process is called depreciation. 

Example: In January 1, 2000 the company buys a delivery truck for 12,000. They expect the
truck to last 5 years. They decide to use the straight line method, with a salvage value (SV) of
Br2,000. The depreciable value is Br10,000 (Br12,000 cost - Br 2,000 SV). The annual
depreciation expense is Br2,000 (Br10,000/ 5 years).
  At the end of 5 years, the company has expensed Br10,000 of the total cost. The Br2,000
salvage value remains on the books. 
General Journal
Date Account Debit Credit
  Jan. 1, 2000 Delivery Trucks Br12,000  
     Cash    Br12,000 
  To record purchase of delivery truck    
       
Dec-31 Depreciation Expense Br2,000  
    Accumulated Depreciation   Br2,000
  To record depreciation expense for the year    
Book Value & Salvage Value
Book value is the difference between the cost of an asset, and the related accumulated
depreciation for that asset 

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 Book Value = Cost - Accumulated Depreciation
Book Value = (Br12, 000 - Br10, 000) = Br2, 000
The company will stop depreciating the truck after the end of the fifth year. The truck cost
Br12,000, but only Br10,000 in depreciation expense was taken. The remaining book value is
equivalent to the salvage value established when the vehicle was purchased. Book value will be
used to calculate any gain or loss when the truck is sold or traded

Preparing a Work Sheet

The work sheet is an informal working paper that the accountant uses in preparing financial
statements and completing the work of accounting cycle. The work sheet has been described as
the accountant’s scratch pad, and it is used to:
1. Organize data
2. Lessen the possibility of overlooking an adjustment
3. Provide an arithmetical check on the accuracy of work, and
4. Arrange data in logical form for the preparation of financial statements. A work sheet is
not a permanent accounting record; it is neither a journal nor a part of the general ledger.
The use of work sheet is optional.

Steps in preparing a Work Sheet

Step 1: Prepare a trial balance on the work sheet.
Step 2: Enter the adjustments in the adjustment columns.
Step 3: Enter adjusted balances in the adjusted trial balance columns.
Step4: Extend adjusted trial balance amounts to appropriate financial statements columns.
Step 5: Total the statement columns, compute the net income (or net loss), and complete the
work sheet.
Illustration: The following information pertains to Hope Laundry at July 31,2008, the end of the
current fiscal year, and the data needed to determine year end adjustments:

Cash Br7,790
Laundry supplies 4,750
Prepaid insurance 2,825
Laundry equipment 85,600
Accumulated depreciation Br55,700
Accounts payable 4,950
Hope, capital 30,900
Hope, Drawing 18,000
Laundry Revenue 76,900
Wages expense 24,500
Rent expense 15,575
Utilities expense 8,500
Miscellaneous expense 910

Adjustment Data:
a) Inventory of laundry supplies at July 31…………Br1,840
b) Insurance premium expired during the year……… 1,500
c) Depreciation on equipment during the year………. 5,720
d) Wages accrued but paid at July 31………………... 850
Instructions:
1) Record the trial balance on a ten column work sheet.
2) Prepare financial statement from the work sheet:
a) income statement,

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 b) Owner’s equity and
c) Balance sheet
d) Journalize the adjusting entries
e) Journalize the closing entries

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1. Ten Column Worksheet
Hope Laundry
Work Sheet
For the year Ended July 31, 2008
Trial Balance Adjustments Adjusted trial Balance Income Statement Balance Sheet
Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr
Account Titles
Cash Br7,790 Br 7,790 7,790
Laundry supplies 4,750 2,910(a) 1,840 1,840
Prepaid insurance 2,825 1,500(b) 1,325 1,325
Equipment 85,600 85,600 85,600
Accu. Br 55,700 5,720(c) 61,420 61,420
depreciation
Accounts payable 4,950 4,950 4,950
Hope, capital 30,900 30,900 30,900
Hope, Drawing 18,000 18,000 18,000
Laundry Revenue 76,900 76,900 76,900
Wages expense 24,500 850(d) 25,350 25,350
Rent expense 15,575 15,575 15,575
Utilities expense 8,500 8,500 8,500
Miscella. expense 910 910 910
Totals Br 168,450 Br168,450
Supplies expense 2,910(a) 2,910 2,910
Insurance expense 1,500(b) 1,500 1,500
Deprec. expense 5,720(c) 5,720 5,720
Wages payable 850(d) 850 850

Totals Br 10,980 Br 10,980 Br 175,020 Br 175,020 60,465 76,900 114,555 98,120

Net income(net loss) 16,435 16,435
Br 76,900 Br 76,900 Br 114,555 Br 114,555
Totals

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The preparations of financial statements from the work sheet of Hope Laundry are presented
below.
Hope Laundry
Income Statement
For the Year Ended July 31, 2008
Revenues
Laundry Revenue 76,900
Expenses:
Wages Expense Br.25, 350
Rent expense 15,575
Supplies expense 2,910
Insurance Expense 1,500
Utilities Expense 8,500
Depreciation Expense 5,720
Miscellaneous expense 910
Total Expense 60,465
Net Income 16,435

Hope Laundry
Owner’s Equity Statement
For the year Ended July 31,2008

Hope, Capital, June 1 Br. 30,900

Add: Investment -0-
Net Income 16,435
Less: Drawing (18,000)
Hope, capital, October 31 Br 29,335

Hope Laundry
Balance Sheet
July 31,2008
Assets
Cash Br.7,790
Laundry Supplies 1,840
Prepaid Insurance 1,325
Laundry Equipment 85,600
Less: Accumulated Depreciation 61,420 24,180
Total Assets Br. 35,135
Liabilities and Owner’s Equity
Liabilities
Account Payable 4,950
Wages Payable 850
Total Liabilities 5,800
Owner’s Equity
Hope, Capital 29,335
Total Liabilities and Owner’s Equity Br. 35,135
(2) Preparing Adjusting Entries from a Work Sheet
The adjusting entries are prepared from the adjustment columns of the work sheet.
The reference letters in the adjustment columns and the explanation of the adjustments
that appear at the bottom of the work sheet help identify entries.
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 The journalizing and posting of adjusting entries follows the preparation of financial
GENERAL JOURNAL Page 18

Date Account Titles and Explanation Ref. Debit Credit

Adjusting Entries
2008
July 31 Laundry Supplies Expense 2,910
Laundry Supplies 2,910
(To record supplies used)
31 Insurance Expense 1,500
Prepaid Insurance 1,500
(To record insurance expired)
31 Depreciation Expense 5,720
Accumulated Depreciation- equip. 5,720
(To record yearly depreciation)
31 Wages Expense 850
Wages Payable 850
(To record accrued salaries)

statements when a work sheet is used.

The adjusting entries on July 31 for Hope Laundry are shown below:

Nature of the Closing Process

At the end of the accounting period, the temporary account balances are transferred to the
permanent of owner’s equity account, owner’s capital.
 The process of transferring the balances of the temporary accounts to the owner’s account
is called the Closing process.
 Entries necessary to accomplish the closing process are called Closing entries.
 All temporary accounts are closed and include all income statement accounts and
owner’s drawing.
 Permanent or real accounts relate to one or more future accounting periods. They consist
of all balance sheet accounts including owner’s capital.
 Permanent accounts are not closed. Instead, their balances are carried forward into the
next accounting period.
 Temporary (nominal) accounts are closed and include: Revenue account, all expense
accounts and, owner’s drawing. Permanent (real) accounts are not closed and include: all
asset accounts, all liability accounts and owner’s capital account.
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Preparing Closing Entries
 Journalizing and posting closing entries is a required step in the accounting cycle. This
step is performed after financial statements have been prepared.
Income Summary Account
 The account to which the balances of nominal accounts are transferred at the end of the
fiscal period is named Income summary account or Income and Expenses summary
account.
 Income summary account is a temporary account used to summarize the balances of the
temporary revenue and expense accounts.
 It is also called a clearing account.
 There is no “normal” balance for this account.
 Income summary account never appears on financial statements. This account is placed in
the capital division of the ledger.
Steps in the closing Process:
1) Close the balance of each revenue account in to income summary
2) Close the balance of each expense account in to income summary
3) Close the balance of income summary account to the owner’s capital account
4) Close the balance of the owner’s drawing account directly to the owner’s capital
account
The following steps close a ledger:
General Journal Page 20
Date Account title P/R Debit Credit

2008 Closing Entries

July 31 Laundry 76,90 00
0
Income summary 76,900 0
0

31 Income summary 60,465 00

Wages Expense 25,350 0

Rent expense 15,575 0
Utilities expense 8,500 0
Supplies expense 2,910 0
Insurance expense 1,500 0
Depreciation expense 5,720 0
Miscellaneous expense 910 0
0
0
0
0
0
0
0

31 Hope , Capital 18,000 00

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 Hope, Drawing 18,000 0
0
31 Income Summery 16,465 00
Hope, Capital 16,465

0
0
Post Closing Trial Balance
Checking the accuracy of posting is once again needed after the closing entries are posted to their
respective accounts in the ledger. A Trial Balance used for testing the equality of Debit and
Credit in the ledger after the closing entries have been posted is called a post closing Trial
Balance.

After the closing entries have been posted and the accounts have been balanced and ruled, Debit
must still equal Credit.
Example:

HOPE LAUNDRY
Post Closing Trial Balance
July 31, 2008
Account title Account No Debit Credit

Cash 11 7,790 00
Laundry Supplies 13 1,840 00
Prepaid insurance 14 1,325 00
Laundry Equipment 15 85,600 00
Accumulated Depreciation 61,420
Accounts Payable 21 4,950 00
Wages Payable 22 850 00
Hope, capital 31 29,335 00
Totals 96,555 00 96,555 00

SUMMARY OF THE ACCOUNTING CYCLE

Step 1.Analyze transactions from source documents
During the Step 2.Record transactions in a journal
accounting Step 3. Post from the journal to the ledger
period Step 4. Prepare a trial balance of the ledger
Step 5. Determine needed adjustments
At the end of Step 6. Prepare a work sheet
accounting Step 7. Prepare financial statements from the completed work sheet
period Step 8. Journalize and post adjusting entries
Step 9. Journalize and post closing entries
Step 10. Prepare a post closing trial balance

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 OR

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