Chapter Three: Completion of the Accounting Cycle

When accountants prepare financial statements, they assume that the economic life of the
business can be divided into time periods. Using this accounting period concept, accountants
must determine in which period the revenues and expenses of the business should be reported.
Based on this Revenues and expenses may be reported on the income statement by either;
(1) the cash basis of accounting or (2) the accrual basis of accounting.

Accrual basis of Accounting Vs. Cash basis of Accounting

Accrual basis of Accounting: Revenues are reported in the period they are earned, and
expenses are reported in the period incurred regardless of the time of cash receipt or payment.
Revenues Earned- when a service /product are sold to customers. i.e. when the seller’s side
obligation is complete. Expenses are incurred when the service of some asset is used, when
some assets are consumed or when the services of some Employees or party is used rather
than when cash is paid. Accrual basis of Accounting is used by most business enterprises and
it is in line with GAAPs basically the matching principle.

Cash 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. Under this system, Net income (or
net loss) is the difference between cash receipts and cash disbursements in operating activity.
Small service enterprises, which have few receivables and payables such as accountants,
physician, may use the cash basis of accounting. It is not in line with GAAPs; basically it
violates the matching principle.

Nature of the adjusting process

Financial reporting on annual, quarterly or monthly basis requires accountants to summarize
the operations of business enterprises for specific time period. All the trial balance amounts
are not necessarily correct at the end of a particular period because of adjustment
requirements. The entries required at the end of an accounting period to bring the accounts
up-to-date and to assure proper matching of revenues and expenses are called adjusting
entries. Adjusting entries are required only under accrual basis of accounting.
Note the following;

 If all financial events are recognized on a day-to-day basis, there is no need of

adjusting entry.
 Every adjusting entry affects both a balance sheet account and an income statement
account.
Generally, there are two types of Adjusting entries:
1. To apportion prepayments of Expenses or pre collection of Revenue (Deferrals)
2. To record Accrued Expenses and Revenue (Accruals)

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Purpose of adjusting Entries
1. To measure all assets and Liabilities correctly
2. To measure net income correctly by matching expired costs (Expenses) with
realized revenue

Figure 1: the two basic classifications of items that give rise to adjustment entries

Deferrals: Prepaid expenses and Pre-collected Revenue

a. Apportionment of rerecorded costs:

Prepayments (prepaid expenses): This include adjustment for Supplies, Prepaid Rent,
Prepaid insurance, etc. There are two alternative ways of recording the prepayments initially.
Accordingly there the adjustments required vary based on the initial record.

Pre-payments are initially recorded in asset account: under this approach adjusting entry
reduces asset account and increase expense account for the amount of asset consumed or for
cost expired during a period.

Example: 1. According to the Hill photographic studio trial balance, the balance in trial
balance for supplies account is 1850. Clearly some of these supplies have been used during
the past month (March) and some may be still in stock. Therefore either of this information is
used to enter the required journal entry to update supplies account and supplies expense
account. Assuming that the inventory supplies on March 31 is determined to be 890.Look on
the computation below:

Supplies available on book (Balance in the account) 1850

Less: Supplies on hand (inventory) (890)
Supplies used (amount of adjustment) 960

Accordingly, adjusting entry- decrease asset account and increase expense account for the
amount of adjustment (supplies used up):

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 Supplies Supplies Expense
Mar 1 1,200 960
Mar 20 650
1,850
Mar 31. 960
Bal. 890

Example: 2. The debit balance of 2400 in Hill’s prepaid rent account represents a pre-
payment on March 1 of rent for three months (March, April and May). At the end of March,
the rent expense account should be increased (debited) and the prepaid Rent account should
be decreased (credited) by the amount of prepaid rent expired for March; 2400/3 = 800
Prepaid Rent Rent Expense
Mar 1 2,400 800

800
Bal. 1600
If the preceding adjustments for supplies (960) and prepaid rent (800) are not recorded, the
financial statements prepared as of March31, will be incorrect (misleading); on income
statement supplies expense (by 960) and rent expense (by 800) totally for 1760 will be
understated leading an overstatement in net income for the same amount, 1760.Similarly, on
owners’ equity the overstatement in net income will result in overstating the ending owners’
equity (capital) by the same amount, 1760. Furthermore, the effect of the omission of this
adjusting entry is reflected on balance sheet as assets (supplies and prepaid rent) are
overstated for 1,760 in total (supplies by 960 and prepaid rent by 800).
Pre-payments are initially recorded in an Expense account Under this approach, adjusting
Entry reduce expense account and increase asset account for the amount of asset not yet
consumed or cost not expired.

Example 1: If Hill recorded purchase of supplies in a supplies expense account at the time
of purchase; before adjustment supplies Expense Account has a debit balance of 1850. The
adjusting entry reduces the supplies expense account and increase the supplies account for the
unconsumed part of supply.
Supplies Expense Supplies
Mar 1 1,200 890
Mar 20 650
1,850
Mar 31. 890
Bal. 960
Example 2: Similarly if Hill recorded payment of rent in advance as an expense (Rent
Expense) before adjustment Rent Expense account has a debit balance of 2400. Therefore,

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the adjusting entry reduce Rent Expense account and increase the asset pre-paid rent for the
amount of pre-payment not yet expired( the remaining two Months on March 31).
Rent Expense Prepaid Rent
Mar 1 2,400 1,600

1,600
Bal. 800
b. Apportionment of Recorded Revenue:
When a business enterprise receives payment for goods and services before goods are
delivered or the services are performed, a liability exists until performance takes place. When
cash is received, the original transaction may be recorded by a credit to a liability known as
Unearned Revenue account or to a Revenue account.
Advance (pre) collection is initially recorded in a liability account: Under this approach
adjusting Entry reduce the liability account and increase the Revenue account for the earned
portion of revenue during the period. The earned portion means part for which the business
side obligation is completed/ goods or services for which the cash is received in advance are
delivered to the client.
Example: Assume that customer paid 500,000 birr for magazine subscription at the beginning
of the year. Assuming that only magazines having a price of 425,00birr have been delivered
to customers during the year; and the collection of cash was initially recorded as a liability the
following adjusting entry is required at end of this year:
Unearned Subscription 425,000
Subscriptions Revenue 425000
Advance (pre) collection is initially recorded in a revenue account: under this approach
adjusting Entry: - Reduce the revenue account and increase the liability account for the
Unearned portion of revenue during the period.
Example: Assume the above example, except the initial collection of cash was recorded in a
revenue account.
Subscriptions Revenue 75,000
Unearned Subscription 75,000
Accruals: To record Accrued Expenses and Revenue
a) Accrual of unrecorded Expenses

Accrued Expenses or accrued liabilities are expenses that have been incurred but have not
been recorded in the accounts. The incurring of certain expenses is related to the passage of
time. The expenses generally are not recorded until payment is made, unless the end of
accounting period comes before the required date of payment. Examples: Interest, salaries,
Taxes, etc. In order to measure expenses accurately for a period, an adjusting entry is
necessary to record the accrued expenses and the corresponding liability.

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Example: The debits of 575 on March 13 and 27 in a salary expense account for Hill
photographic studio were biweekly payments on alternate Fridays for the payroll periods
ended on those days. The salaries earned on Monday and Tuesday March 30 and 31, total
115. This amount is additional expense of March 31, therefore credited to Salaries payable:

Salaries Expense 115

Salaries Payable 115
b) Accrual of Unrecorded Revenue
Revenue that has been realized but not recorded must be recognized at the end of an
accounting period. Accrued revenues or accrued assets are revenues that have been earned but
have not been recorded in the accounts. Examples include: Fees for services that an attorney
has provided but has not billed to the client at the end of the period, unbilled commissions by
travel agent, accrued interest on notes receivable, and accrued rent on property rented to
others. In order to measure accurately the results of operations, revenues are recognized in the
period earned.
Example: Assume that rent totaling 625 that has been realized but not collected for the
month of adjusting entry on December 31, is required to measure assets and Revenue
correctly.
Rent Receivable 625
Rent Revenue 625
Preparation of Worksheet
Worksheet is a working paper that accountants can use to summarize adjusting entries and the
account balances for financial statements. A worksheet is an important tool, but is not an
essential part of the accounting system, like accounts, journal, or ledger; for example for small
companies with few accounts and adjustments, a worksheet may not be necessary.
The work sheet is identified by: the name of the enterprise, the nature of the form (work
sheet), and the period of time involved.
A commonly used worksheet has an account title column and ten (10) columns divided in to
five pairs of debits and credit columns.
The main headings of the five pairs of money columns are: Trial Balance, Adjustments,
Adjusted Trial Balance, Income Statement, and Balance sheet.
Financial Statements
Work sheet is an aid in preparing financial statement. The income statement, statement of
owner’s equity and balance sheet prepared from work sheet. For Hill Photographic Studio, the
financial statements are presented as follows:

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 Hill Photographic Studio
Income Statement
For Month Ended March 31, 1990
Sales 5,525
Operating Expenses:
Salary Expense 1,265
Supplies Expense 960
Rent Expense 800
Depreciation expense 175
Miscellaneous Expense 369
Total Operating Expenses 3,569
Net Income 1,956
Hill Photographic Studio
Statement of Owner’s Equity
For Month Ended March 31, 1990
Ann Hill Capital, March 1, 1990……………… 20,650
Net Income for the Month…………………….….... 1956
Less: Withdrawals……………………………….… 1500
Increase in Owner’s equity…………………….……. 456
Ann Hill Capital, March 31, 1990………………...… 21106
Hill Photographic Studio
Balance Sheet
March 31, 1990
Assets
Current Assets:
Cash 1,631
Account Receivable 1,775
Supplies 890
Prepaid Rent 1,600
Total Current Assets 5,896
Plant Assets:
Photographic Equipment 17,500
Less: Accumulated Depreciation 175 17,325
Total Assets 23,221
Liabilities
Current Liabilities:
Account Payable 2,000
Salaries Payable 115
Total Liabilities 2,115
Owner’s Equity
Ann Hill, Capital 21,106
Total Liabilities and owner’s Equity 23,221
Closing Entries
Nature of the Closing Process
There are two types of accounts:
a) Temporary or nominal accounts
 They serve only for a given accounting period and it includes;

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  All income statement accounts and
 Drawing account
 They are closed at the end of the accounting period
b) Permanent or real accounts
 They include all balance sheet accounts including owner’s capital
 They are not closed but their balances are carried forward to the next accounting period.
The Revenue, Expense, Drawing (dividend) accounts is temporary accounts used in
classifying and summarizing changes in the Owner’s Equity during the accounting period.
To report amounts only for one period temporary account should have zero balances at the
beginning of a period.
Closing entries transfer the balances of temporary accounts to the owner’s capital account.
An account titled “Income summary” is used for summarizing the data in the revenue and
expense accounts. It is used only at the end of the accounting period and is both opened and
closed in the closing process.
Four entries are required in order to close temporary accounts of a sole proprietor ship at the
end of a period:
1. To close all revenue accounts: Each Revenue account is debited for the amount of its
balance, and Income Summary is credited for the total revenue.
Revenue 1 Xxx
Revenue 2 Xxx
Revenue 3 Xxx
Income Summary xxx
2. To Close all expense accounts: Each expense account is credited for the amount of its
balance, and Income Summary is debited for the total expense.
Income Summary Xxx
Expense 1 xxx
Expense 2 xxx
Expense 3 xxx
3. To Close the Income Summary account: Income Summary is debited for the amount
of its balance (net income) and the capital account is credited for the same amount.
(Debit and credit are reversed if there is net loss.)
4. To close the drawing account: The drawing account is credited for the amount of its
balance, and the capital account is debited for the same amount. The same is true for
dividend account, dividend account is credited for its balance and Retained Earnings is
debited for the amount

Example- for Hill photographic studio see the data from previous illustration or worksheet in
annex.

1. To close Revenue:
Sales 5525
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 Income Summary 5525
2. To close Expenses:
Income Summary 3569
Salary Expense 1265
Miscellaneous Expense 369
Supplies Expense 960
Rent Expense 800
Depreciation Expense 175
3. To close the Income Summary:
Income Summary 1956
Ann Hill, Capital 1956
4. To close Drawing account
Ann Hill, Capital 1,500
Ann Hill, Drawing 1,500
Post-Closing Trial Balance
The last procedure of the accounting cycle is the preparation trial balance after all of the
temporary accounts have been closed. The purpose is just to make sure that the ledger is in
balance at the beginning the new accounting period. The account titles & amounts should
agree exactly with the accounts & amounts listed on the balance sheet at the end of the period.

Hill photographic studio

Post-closing Trial Balance
March 31, 1990
Cash 1,631
Accounts Receivable 1,775
Supplies 890
Prepaid Rent 1,600
Photographic Equipment 17,500
Accumulated Depreciation-Photographic 175
Equipment
Accounts payable 2,000
Salaries payable 115
Ann Hill, Capital 21,106
Total 23,396 23,396

Reversing Entries
Reversing entries are optional journal entries made at the beginning of a new accounting
period to cancel out certain adjusting entries made in the previous period. They simplify the
accounting process for the next period, particularly with respect to accrued expenses and
revenues.

Here's how to make reversing entries based on the examples provided

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1: Reversing an Accrued Expense
At the end of March, an accrued expense was recorded for salaries earned but not yet paid.
The adjusting entry made was:
Adjusting Entry for Accrued Salaries:
Salaries Expense…………….. 115
Salaries Payable………………….. 115
Reversing Entry on April 1: To reverse this entry, you would debit Salaries Payable and credit
Salaries Expense:
Salaries Payable…………………. 115
Salaries Expense………………………… 115
Example 2: Reversing an Accrued Revenue
If you recorded accrued revenue for rent that was earned but not yet received at the end of
March, the adjusting entry was:
Adjusting Entry for Accrued Rent Revenue:
Rent Receivable……………………….. 625
Rent Revenue…………………………….. 625
Reversing Entry on April 1: To reverse this entry, you would debit Rent Revenue and credit
Rent Receivable:

Rent Revenue…………………… 625

Rent Receivable………………………… 625
Purpose of Reversing Entries
Simplification: They simplify the recording of transactions in the new period. For instance,
when the actual cash payment or receipt occurs, you can record it without considering the
previous adjustments.
Accuracy: They help ensure that revenues and expenses are not double-counted in the new
period.

Summary
The accrual basis of accounting requires that revenues are reported in the period in
which they are earned and expenses matched with the revenues they generate. The
updating of accounts at the end of the accounting period is called the adjusting process.
Each adjusting entry affects an income statement and balance sheet account.
The four types of accounts requiring adjusting entries are prepaid expenses, unearned
revenues, accrued revenues, and accrued expenses.
After all the adjusting entries have been posted, the equality of the total debit balances
and total credit balances is verified by an adjusted trial balance.
The work sheet is an important working paper for accountants to compile all necessary
information necessary in preparation of financial statements, however is not mandatory
Post-closing trial balance is prepared after all temporary (nominal) accounts are closed
to verify the equality of debits with credits.

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Reversing entries are a practical tool in the accrual accounting process, allowing for
clearer financial reporting and easier transaction management in subsequent accounting
periods. By systematically canceling out certain adjustments, businesses can maintain
the integrity of their financial statements while easing the burden of accounting for
accrued items in the following period.

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