Professional Documents
Culture Documents
CHAPTER TWO
2. The Account
A. Classification
The accounts in the general ledger are arranged in the same order that they
would appear in the financial statements.
Balance sheet accounts are placed first, followed by the income statement
accounts.
ASSETS
i. Current assets
- Cash
- Notes receivable
- Accounts receivable
- Inventory
- Prepaid expenses
LIABILITIES
a. Current liabilities
- Notes payable
- Accounts payable
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- Unearned revenue
- Salary payable
- Rent payable
- Interest payable
b. Non-current liabilities
- Mortgage payable
- Bonds payable
- Long term notes payable
OWNER'S EQUITY
REVENUE
- Sales/service revenue
EXPENSES
The number and type of accounts in the chart of accounts of a given business will
depend upon one or more of the following factors:
• The nature of the business and the way it operates.
• The size of the business entity
• The amount of detail needed for management to make its decisions; and
• Rulings of regulatory agencies
In its most elementary form, the account has got three parts:
Cash
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Stores the amounts for future use, and
Shows the account balance.
To facilitate the record keeping process, the accounts in the general ledger
are numbered.
The use of numbers (codes) to identify accounts in business documents is
much easier than use of the account titles.
Each business entity will normally devise its own numbering (coding)
system. An identification number (code) is assigned to each account.
Numbering should not necessarily be consecutive but successive that
allows new accounts to be inserted.
The first digit indicates the major division of the ledger in which the
account is placed.
Accounts beginning with: 1 represent assets
2 represent liabilities
3 represent capital and drawing
4 represent revenues
5 represent expenses
The second digit indicates the position of the account within its division.
The initial preparation of the ledger based on the chart of accounts is
known as Opening the ledger.
A chart of accounts is a listing of the account titles and account numbers being
used by a given business.
Insofar as possible, the order of the items in the chart of accounts should agree
with the order of the items in the balance sheet and the income statement.
Left side of any account is the debit side; and the right side of any account is the
credit side.
Which side should be used to show the increases/decreases?
Debits and credits by themselves do not indicate increases or decreases. We must
refer to a specific account to determine if a debit or a credit represents an increase or
a decrease.
Every single financial transaction affects at least two accounts in the general
ledger – an account in which a debit is recorded and an account in which the credit is
recorded.
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The amount recorded in the debit accounts must equal the amount recorded in the
credit accounts.
If one debit account affects more than one credit account, the sum of the credit
accounts affected, of course, must equal the amount of the corresponding debit
account.
Conversely, if one credit account affects more than one debit account, the sum of
the debit accounts must equal the amount of the corresponding credit account.
4. Normal Balances
For any account, the normal situation is for the sum of the increases to be greater
or equal to the sum of the decreases to the account. The resulting balance is greater
than or equal to zero rather than a negative balance. The positive balance of an
account is referred to as its normal balance.
The normal balance of each type of account is always the “increase” side of the
account.
An account that normally has a debit balance may occasionally have a credit
balance, which indicates a negative amount of the item. This is an indication of an
accounting error or of an unusual situation.
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8. The Journal
The journal, or book of original entry, is a chronological record, showing for each
transaction the debit and credit changes caused in specific ledger accounts.
A brief explanation may also be included for each transaction.
The unit of organization for the journal is the transaction.
By making use of both a journal and a ledger, we can achieve several advantages,
which are not possible if transactions are recorded directly in ledger account:
It helps to prevent or locate errors because the debit and credit amounts for
each entry can be readily compared.
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a. Record the date- this specific step involves the recording of the date of
the year, the month, and the specific day in which the
transaction has occurred.
b. Record the debit- this step involves entering the title of the account to
be debited along with the related amount.
c. Record the credit- this step involves entering the title of the account to
be credited along with the related amount.
Remarks:
12. Posting
Refers to the process of transcribing the debits and credits in each journal entry to
the appropriate general ledger account.
T-accounts are simplified representation of actual general ledger accounts.
Three standard formats of a ledger account are widely used:
Two-column ledger account
Three-column ledger account
Four-column ledger account
Balance
Date Explanation P/R Debit Credit Debit Credit
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13. Steps In Posting
ABC Co.
General Ledger
Page 001
Date Description P/R Debit Credit
1991
May 1 Cash 110 xxxxxx
Sales xxxxxx
To record cash sales
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May
A two-column schedule that lists the titles and debit and credit balances of all the
accounts in the order in which they appear in the ledger.
The agreement of the debit and credit totals of the trial balance gives assurance that:
1. Equal debits and credits have been recorded for all transactions.
2. The debit or credit balance of each account has been correctly computed.
3. The addition of the account balances in the trial balance has been correctly
performed.
When the trial balance does not balance, this situation indicates that one or more errors
have been made. The errors may have been:
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5. In adding the columns of the trial balance.
The lack of balance in the trial balance may be the result of a single error or a
combination of several errors.
What is the most efficient approach to locating the error (or errors)?
There is no single technique, which will give the best results every time, but the
following procedures, done in sequence, will often save considerable time and effort
in locating errors.
Procedures to locate errors:
i. Prove the addition of the trial balance columns by adding the
columns in the opposite direction from that previously followed.
ii. Determine the exact amount at which the schedule is out of
balance. This amount may provide a clue to discover errors such as:
♦Interchange of debits and credits
♦Transposition of numbers
♦Slides
♦Amounts omitted
iii. Compare the amounts in the trial balance with the balances in
the ledger,
iv. Recompute the balance of each ledger account,
v. Trace all postings from the journal to the ledger.
18. Adjustments
The basic elements of the accounting model are never precisely measured on the
financial statements of a business enterprise.
Only after completing all the business transactions over the entire life of a
business entity, can the exact amount of assets, revenues, expenses, and net income
be determined.
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For example, assume a building with a cost of Br.2,400,000 whose expected life
is 40 years.
But 25 years later the building no longer serves its original purpose.
However, the actual yearly expense turned out to be 2,400,000/25 = Br. 960,000.
The precise amount of the yearly expense can be determined only after the useful life
of the building has passed.
However, decision makers such as managers and investors can't wait for the
business to conclude its operations before they evaluate its financial progress.
Instead, they expect a business to provide financial reports periodically.
To provide timely information in financial statements, accountants break the life
of business entities into time frames. At the end of each time frame, accountants
prepare financial statements.
These time frames are referred to as Accounting periods and are typically a year,
a quarter, or a month in length.
The breaking of the entire of an entity's life into time schemes is justified by the
periodicity assumption.
The primary accounting period used by most businesses is one year, for which
they prepare annual financial statements.
One major advantage of recognizing the life of the business as a series of regular,
successive accounting periods is comparability.
Businesses also prepare interim financial statements/reports based on one-
month or three-month accounting periods.
On the date of purchase the policy may be recorded as a prepaid insurance (asset).
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But three months later, on December 31, only 9 months of insurance coverage
remain, while three months insurance expense has been incurred.
The financial statements prepared at the end of the accounting period must reflect
the shifts in asset and expense values. The financial statement must show the
following:
There are two widely used basis of Accounting: The accrual basis of accounting
and the cash basis.
The accrual basis
An accountant recognizes the impact of a business event as it occurs.
When the business performs a service, makes a sale, or incurs an expense,
the accountant enters the transaction into the books, whether or not cash
has been received or paid.
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(1) Timing: When to record revenue.
Example:
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2. Accrual - includes revenue already earned and expenses already incurred for
which no transaction has yet been recorded.
24. Illustrations
A. Deferrals as Assets/Liabilities
i. Prepaid Insurance
ABC Co. purchased an insurance policy for Br. 6,000 on Oct. 1, 2002 to
cover one-year period.
On Nov. 1, rent at Br. 150 per month for 3 months was paid in advance by
ABC business.
On Nov. 8, ABC business paid cash of Br. 386 for office supplies.
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At the end of November, supplies on hand were counted and only supplies
costing Br. 133 remained. Thus, the adjusting entry required would be:
On Nov. 1, ABC business has received cash of Br. 600 in advance of the
actual services.
B. Deferrals as Expenses/Revenues
i. Prepaid Insurance
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ii. Prepaid Rent
iii. Supplies
C. Depreciation
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The accumulated depreciation is a contra–asset account to a plant asset
account and has credit normal balance.
D. Accruals
i. Accrued Expenses/Liabilities
Example:
Assume that ABC business pays the weekly salary of employees every Friday. Suppose
further that the daily salary of all employees is Br. 1,064 and that the end of August
31,1999 was on Tuesday. The adjusting entry required as of August 31,1999 is:
Example:
Consider a 12% note payable (Br. 1500) due on March 30,2000. The note
was issued on October 1, 1999
The interest expense incurred on this note until Dec. 31, 1999 is calculated
according to the following formula:
The adjusting entry to record the interest expense incurred in October is:
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Dec. 31. Interest expense ----------------- 45
Interest payable --------------- 45
Examples:
MM has performed consultancy services in the month of August 2002. Billing was not
made until September 15, 2002.
If this was a 12% note receivable rather that a note payable the adjusting
entry would be as follows:
What is it ?????
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It reduces the possibility of introducing errors in that process.
It aids in discovering errors that do occur.
It provides monthly statement without the formal adjusting and closing
process.
The following is the unadjusted trial balance of XYZ Service Company at December
31,19x1, the end of its fiscal year.
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Data needed for the adjusting entries include:
Dear student, please look at the next page for the work sheet.
Even though the worksheet shows the amount of net income or net loss for
the period, it is still necessary to prepare the financial statements.
The worksheet is not a substitute for the financial statements.
This is because the worksheet is only a temporary record that facilitates
the compilation of the data needed to prepare the financial statements, which
become part of the permanent accounting records.
The worksheet provides all the necessary data to prepare the balance sheet,
the income statement, and the statement of owner’s equity.
Financial statements prepared for XYZ Service Company from the
worksheet are as follows:
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XYZ Service Company
Statement of owner's equity
For the year ended Dec. 31, 19x1
Capital, January, 19x1 Br. 293,000
Add: net income 106,000
Subtotal 399,000
Less: withdrawal 65,000
Capital, Dec. 31, 19x1 334,000
The adjusting entries required for XYZ Service Company as at Dec. 31, 19x1 are:
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31. Closing the Accounts
(1) At the end of a period the capital account would reflect a beginning-of-period
balance while all other balance sheet accounts would reflect period-end
balances.
(2) The balances in revenue and expense accounts would not be for the latest
accounting period, but rather would be a cumulative balances, starting from
when the company first commenced operations.
(1) the act of transferring the balances in revenue and expense accounts to a clearing
account called Income Summary Account and then to owner’s capital, and
(2) the act of transferring the balance in the owner’s drawing account to the owner’s
capital account.
33. Thus, the steps in closing the accounts of a proprietorship are as follows:
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35. The Post Closing Trial Balance
XYZ Company
Post closing trial balance
Dec. 31, 19x1
Debit Credit
Cash Br. 198,000
A/receivable 382,000
Supplies 2,000
Furniture & fixture 100,000
Accumulated Depreciation 60,000
Building 250,000
Accumulated depreciation 140,000
A/payable 380,000
Salary payable 5,000
Unearned service revenue 13,000
Capital 334,000
Total Br. 932,000 Br. 932,000
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