CHAPTER 3

THE ACCOUNTING CYCLE

 LEARNING OBJECTIVES

 Explain how the concepts of recognition,

valuation, and classification apply to
business transactions and why they are
important factors in ethical financial
reporting.
 Explain the double-entry system and the
usefulness of T accounts in analyzing
business transactions.
 Demonstrate how the double-entry system is
applied to common business transactions.
 Prepare a trial balance, and describe its
value and limitations.
 Explain how the concepts of recognition, valuation,
and classification apply to business transactions

 Business transactions are economic events that affect a

company’s financial position.
 To measure a business transaction, we must decide

ECONOMIC EVENTS

RECOGNITION when the transaction occurred (the

recognition issue),
VALUATION what value to place on the transaction
(the valuation issue), and
CLASSIFICATION how the components of the
transaction should be categorized (the
classification issue).
BUSINESS TRANSACTIONS THAT AFFECT FINANCIAL POSITION
Recognition
 The recognition issue refers to the decision when a business
transaction should be recorded.
 This issue is important because the date on which a transaction is
recorded affects amounts in the financial statements.
 To illustrate some of the factors involved in the recognition issue,
suppose a company wants to purchase an office desk. The following
events take place:
1. An employee sends a purchase requisition for the desk to the purchasing
department.
2. The purchasing department sends a purchase order to the supplier.
3. The supplier ships the desk.
4. The company receives the desk.
5. The company receives the bill from the supplier.
6. The company pays the bill.
 According to accounting tradition, a transaction should be recorded
when title of merchandise passes from the supplier to the purchaser and
creates an obligation to pay.
 Thus, depending on the details of the shipping agreement for the desk,
the transaction should be recognized (recorded) at the time of either
event 3 or 4.
 The preset time at which a transaction should be
recorded is the recognition point.
 Some examples of economic events that should and
should not be recorded as business transactions:
 Events That Are Not Recorded Events That Are Recorded
 A customer inquires about the A customer buys a service.
availability of a service.
 A company hires a new employee. A company pays an employee
for work performed.
 A company signs a contract to A company performs a service.
provide a service in the future.
Valuation
 The valuation issue focuses on assigning a
monetary value to a business transaction.
 GAAP states that all business transactions
should be valued at fair value when they occur.
 Fair value is defined as the exchange price of an
actual or potential business transaction between
market participants.

 This practice of recording transactions at

exchange price at the point of recognition is
commonly referred to as the cost principle.
Example: Determine the value of the following transaction.

 A company provides printing paper to a local weekly

newspaper printing press in exchange for an advertisement

for 52 issues.

 Determining the value of a sale or purchase transaction isn’t difficult

when the value equals the amount of cash that changes hands.
However, barter transactions, in which exchanges are made but no
cash changes hands, can make valuation more complicated. Barter
transactions are quite common in business today.
Classification

 The classification issue has to do with

assigning all the transactions in which a
business engages to appropriate categories
 Assets
 Liabilities
 Capital
 Revenue
 Expenses and costs
 The Role of Accounting Records

All accountants play a pivotal roll in establishing and maintaining

economic information about the company.

Establishes accountability for assets and other transactions.

Keeps track of routine business activities.

Obtains detailed information about a particular transaction.

Evaluates efficiency and performance within company.

Maintains evidence of a company’s business activities.

 The accounting process

Inputs Process Outputs

1) Income
Statement
1. Accounts 2) Balance Sheet
2. Journal 3) Cash Flow
3. General
Ledger
4. Trial
Balance

What is the chart of accounts?

It is the list of accounts used by a business.

Each business entity has its unique chart of accounts.
Every chart of accounts has the same numbered account
categories:
– Assets, Liabilities, Owner’s Equity
– Revenues, Expenses and costs
 JOURNAL
What is a journal?
It is the book of original entry.
Initially transactions are recorded in a journal and then
transfer to the general ledger accounts.
Journalizing is the process of entering information as
debits and credits to the correct accounts.
The steps in journalizing
In journalizing Debits are always recorded first.
Indent, then record the credit below the debit.
A short explanation is included on the second line.
Leave a space between journal entries.
The Ledger
 An accounting system has a separate record for
each item appears in the financial statements.
 The record used to keep track of the increase and
decrease in financial statement item is termed as a
ledger account or simple an account.
 Accounts are individual records showing increases
and decreases of specific item.
 A group of accounts is called a ledger. It means that
the entire group of accounts is kept together in an
accounting record is called a ledger.
The Use of Accounts
 It is useful to accumulate and summarize the
change of an item due to business transaction
during the accounting period.
 Increases are recorded on one side of the T-
account, and decreases are recorded on the
other side.
 Simplest form of ledger account is “T” account.
 T-account has three elements Title of the Account
 A title part Left Right
 A left side and or or
 A right side Debit Credit
Side Side
 Debit and Credit Rules for different accounts
Debits and credits affect accounts as follows:

A = L + OE
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
for for for for for for
Increase Decrease Decrease Increase Decrease Increase
Double Entry Accounting
The Equality of Debits and Credits
•The rule of debts and credits are designed so that every
transaction is recorded by equal amounts of debits and credits.
•This is due to the relationship of the rule of debits and
credits with the accounting equation.

A = L + OE
Debit
balances = Credit
balances

In the double-entry accounting system, every transaction

is recorded by equal dollar amounts of debits and credits.
Let’s record selected transactions for Abeba’s Care Service company in the
accounts.

 May 1: Abeba and her family invested $8,000 in

her Care Service company and received 800 shares
of stock.

Will Capital Stock

Will Cash increase
increase or
or decrease?
decrease?
The Journal
In an actual accounting system, transactions are initially
recorded in the journal.

GENERAL JOURNAL

Date Account Title P/R Debit Credit

2007 1 Cash 8 000
May

Capital stock 8 000

CK. No. 1 owners invest cash in the
business
Posting Journal Entries to the Ledger Accounts

 All transactions are recorded in the journal, then amounts

are copied to the ledger accounts named on the journal
line.

 Once the amounts are entered into the accounts, a posting

reference (PR) must be entered in the journal.

 New balances are computed in the running ledger

accounts.

 Posting simple means updating the ledger accounts for the

effects of the transactions recorded in a journal.

 Posting involves copying information from the journal to

the ledger accounts.
 Posting Journal Entries to the Ledger
Accounts
GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
2007
May 1 Cash 8,000
Capital Stock 8,000
Ck No. 1 Owners invest cash in the business.

General Ledger
Cash
Date Debit Credit Balance
2007
May 1 8,000 8,000
 Posting Journal Entries to the Ledger
Accounts
GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
2007
May 1 Cash 8,000
Capital Stock 8,000
Owners invest cash in the business.

General Ledger
Capital Stock
Date Debit Credit Balance
2007
May 1 8,000 8,000
 Posting Journal Entries to the Ledger
Accounts
GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
2007
May 2 Tools & Equipment 2,500
Cash 2,500
Purchased office equipment.

Let’s see what the cash account looks like after

posting the cash portion of this transaction for
Abeba’s Care Service company.
Ledger Accounts After Posting

General Ledger
Cash
Date Debit Credit Balance
2005
May 1 8,000 8,000
2 2,500 5,500
This ledger format is referred to as a
running balance.
What is Net Income?
 Net income is an increase in owners’ equity from
profits of the business.
 Net income doesn’t consist of any specific assets.
Rather it is a computation of the overall effect of
many business transactions on owners’ equity
during the accounting period.
 NI may be distributed to shareholders or retain in the
organization, or distribute part of NI and retain the
remaining within the organization.

A = L + OE
Increase Decrease Increase

Either (or both) of these effects occur . . . but this is what “net
as net income is earned . . . income” really means.
Retained Earnings

 The balance in the Retained Earnings account

represents the total net income of the corporation over
the entire lifetime of the business, less all amounts which
have been distributed to the stockholders as dividends.

A = L + OE
Capital
Stock Retained
Earnings
 The Realization Principle: When To
Record Revenue
Realization Principle
Revenue should be recognized at the time goods are sold and
services are rendered. At this point the business transaction has
completed its earning process.
Assume that ABC company has taken a contract on September
2016 to render service to Z company. ABC company
performed the service on October 2016 and will receive
$2000 from Z company on November 20, 2016.
In which month ABC company should recognize the revenue
earned?
 The Matching Principle:
When To Record Expenses
Matching Principle
 According to Matching principle, Expenses should be recorded in the
period in which they are used up to generate revenue.
 In measuring Net income for the period, revenue should offset by all
the expenses incurred in producing that revenue.
 This concept of offsetting expenses against revenue on a basis of
cause and effect is called Matching principle.
Expenses are the cost of the goods and services used up in
the process of earning revenue.
 An expenses always causes a decrease in owner’s equity.
The result of change of an expense transaction in the
accounting equation can be either a decrease in assets or a
increase in liabilities.
...

 Example: On June 10, 2017 ABC company has paid $1000

salaries of May 2017 for its employees. ABC company
prepares financial statements at the end of a month.

 In which month this salaries amount should record in the

book of ABC company?

 In deciding when to record an expense, the critical question

is
 “ in which period does the cash expenditure help to produce
revenue?” not “when does the cash payment occur?”
 Trial Balance

A trial balance is a summary of balances of all

accounts recorded in the ledger.
Objectives of Preparing a Trial Balance
check the arithmetical accuracy of the ledger accounts;
help in locating errors; and
 provide a basis for preparing the financial statements.

The trial balance lists the accounts that have balances

in the same order as they appear in the chart of
accounts.
Trial balance is the proof of debit and credit balances
of all the accounts in the ledger.
 All balances
Abeba’s Care Service company
are taken from
Unadjusted Trial Balance
May 31, 2007 the ledger
Cash $ 3,925 accounts on
Accounts receivable 75 May 31 after
Tools & equipment 2,650
Truck 15,000 considering all
Notes payable $ 13,000 of Abeba’s
Accounts payable 150 transactions
Capital stock 8,000
Dividends 200
for the month.
Sales revenue 750
Gasoline expense 50 Proves equality
Total $ 21,900 $ 21,900 of debits and
credits.
Detection of Errors Revealed by the Non-agreement of
Trial Balance
 If the trial balance does not balance, the accountant should
initiate the following steps to detect and locate the errors:
 Recast the totals of debit and credit columns of the trial balance.

 Compare the account head/title and amount appearing in the trial

balance, with that of the ledger to detect any difference in amount or
omission of an account.

 Re-do and check the correctness of balances of individual accounts

in the ledger.

 Re-check the correctness of the posting in accounts from the books

of original entry.
... If the difference between the debit and credit columns is
divisible by two, there is a possibility that an amount equal to
one-half of the difference may have been posted to the wrong
side of another ledger account.
 The difference may also indicate a complete omission of a
posting.
 If the difference is a multiple of 9 or divisible by 9, the mistake
could be due to transposition of figures.
For example, if a debit amount of $ 459 is posted as $954,
the debit total in the trial balance will exceed the credit side by $
495 (i.e. 954- 459 = 495). This difference is perfectly divisible by
9.
 A mistake due to wrong placement of the decimal point may
also be checked by this method. Thus, a difference in trial
balance divisible by 9 helps in checking the errors for a
transpose mistake. Example. $478.5 posted as $4785.00;
difference $4785.00-478.50= 4306.50 divided by 9 = 478.50
Errors Disclosed by Trial Balance
 If the Trial Balance does not balance, it will indicate that
certain errors have been committed which have affected the
agreement of the Trial Balance. The accountant will then
proceed to find out the errors and ultimately the errors will be
located.
 Such errors are called 'Errors Disclosed by Trial Balance or
Errors which affect the agreement of Trial Balance.
 Wrong amounts in the ledger
 Posting to the Wrong Side of an account
 Posting of Wrong Amount to an account
 Omission of Posting of One Side of an Entry
 Double posting in a Single Account
 Errors of Totalling and Balancing of Accounts in the Ledger
Errors that can not disclosed by trial balance
 There are many benefits of trial balance but there are also numerous errors
which can not be disclosed or revealed from making trial balance.
1. Errors of omission
If we forget to pass the journal entry of any transaction, both side of trial
balance will not be affect with this.
2. Errors of commission
These types of errors are happened due to negligence of accountant and can not
be found by making trial balance. Suppose, we sold of $ 10,000 goods but
recorded in books as $1000.
3. Errors of compensating
Suppose, accountant wrote $ 500 less in the debit side of purchase account and
same time he also wrote $500 less in credit side of sale account. Because one
mistake is compensated with other error.
4. Writing the amount to the correct side but to the wrong account
Suppose if you have purchased machinery but you debited purchase account in
journal entry.
5. Errors of duplicating : pass the journal entry twice