CHAPTER TWO

2. Information Processing and Accounting Cycle

Accounting cycle is a complete sequence of accounting procedures that are repeated in the same order during
each accounting or fiscal period.

The accounting process consists of two interrelated parts:

i. the recording phase, and

ii. the summarizing phase
Recording is a continuous process (i.e., it is not a one-time task). Accountants record transactions as they
occur, reflecting the situation as it exists at the time of the transaction. Once all transactions are recorded,
accountants perform the summarizing function.

The accounting process is a series of activities that begins with a transaction and ends with the closing of the
books. Since this process is repeated each reposting period, it is referred to as the accounting cycle and
includes the following major steps:

I. The recording phase:

The steps under this phase are performed throughout the accounting period when transactions occur or in
periodic batch process.

1. Identify the transaction to be recorded (because all events cannot be recorded).

2. Prepare or obtain the transaction’s supporting document (source document) such as sales invoice,
purchase invoice, etc.
3. Analyze and classify the transaction. Analyzing the supporting documents will provide the basis for
making an initial record of each transaction. This step involves quantifying the transaction in terms of
money, identifying the accounts that are affected, determining the effect in terms of increase or
decrease in the accounts affected, and whether these accounts are to be debited or credited.
4. Record the transactions by making entries in the appropriate journal. Transactions are record in
chronological order in books of original entry (journal).
5. Post general journal entries to the ledger account. Transactions are posted to the appropriate accounts in
the general, and where applicable, to subsidiary ledgers.

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 II. The summarizing phase:

The following steps are performed at the end of the accounting period:

6. Prepare a trial balance of the accounts in the general ledger. This is done in order to check if total debits
are equal to total credits.
7. Prepare adjusting entries to recorded accrued, deferred, and estimated amounts and post them to ledger
accounts. Before preparing financial statements, all relevant information that has not been recorded
must be determined. Often adjustments are first made on a work sheet and may be formally recorded
and posted at any time prior to closing. If a works sheet is not used, the adjusting entries must be
recorded and posted at this point so that the accounts are current (up to date) prior to the preparation of
the financial statements.
8. Prepare the financial statements.
Statements summarizing operations and showing the financial position and cash flows are prepared
from the information on the work sheet or directly from the adjusted accounts.

9. Preparing closing journal entries that close temporary (nominal) accounts. Balance in the nominal
accounts such as revenues, expenses, gains and losses are closed to a temporary income summary
account. As determined in the summary account, the result of operations is transferred to the
appropriate owners’ equity account. Any dividend or withdrawal (drawing) account(s) is closed to
capital account, i.e. retained earnings or owners’ equity account(s).
10. Prepare the post (after) closing trial balance (optional). A post-closing trail balance is taken to
determine the equality of the debits and credits after posting the adjusting and closing entries. In the
post-closing trail balance, only the permanent accounts will appear as the temporary ones are already
closed.

11. Prepare reversing journal entries (optional). Reversing journal entries often are used when there has
been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting
period. This step is not a requirement; rather it may be desirable as a means of facilitating recording and
adjusting routines in the succeeding period. A reversing journal entry is recorded on the first day of the
new period.

2.1. Identifying and Analyzing business transaction

A transaction is an event that causes a change in the assets, liabilities, or owners’ equity of a business
enterprise. This is an event which has an impact on the company and could be expressed in terms of money.
Transactions may be classified into two broad groups:

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 i. External transactions: or those between the business enterprise and another entity.
E.g. purchase of goods from a supplier, sales of goods to customers, borrowing money from a bank.

ii. Internal transactions: such as the expiration or transfer of cost within the enterprise.
E.g. Depreciation of plant assets, transfer of production costs from work in process inventory to the
finished goods inventory.
2.2. Preparation of source documents
Source document is supporting evidence to provide written evidence that a transaction has occurred indicating
the data, amount, parties involved, and nature of the transaction. They are business papers into which an
occurrence of every economic event is written and from which an accounting record is made. They are also
called business papers or vouchers. The common source documents for frequently occurring transactions
include:

 Sales invoice for credit sales

 Purchase invoices for purchase of supplies; and
 Cash register tapes for cash sales
2.3. Analyzing Business Transactions
After transactions are identified, they should be analyzed in order to determine their impact on the financial
position of the firm as represented by the basic accounting equation:

Assets = Liabilities + Owners’ Equity

Debit (+) Credit (-) Debit (-) Credit (+) Debit (-) Credit (+)

Dividend (Drawing) Expenses Revenue

Debit (+) Credit (-) Debit (+) Credit (-) Debit (-) Credit (+)

The analysis occurs within the double entry system of accounting. Double entry accounting system is
universally accepted system for recording accounting data. As the name implies, the journal entry made for
each transaction is composed of two parts: one or more debits and one or more credits. For each transaction
recorded, the total amount of the debits entered in all the related accounts must be equal to the total amount of
the credits.
The double entry accounting system has the following advantages;

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  It has built in controls to detect errors i.e. the sum of all debits must equal sum of credits, if this
equality is not maintained; it is the indication for errors while recording.
 It is self-balancing that facilitates preparation of the complete set of financial statements as frequently
as desired.
Before a transaction is recorded in a journal, it should be analyzed in terms of three issues:
i. Determine the item affected: asset, liability, owner’s equity, revenue, or expenses
ii. Determine the effect of transaction on the respective accounts: increase or decrease; and
iii. Determine the account side into which the effect of the transaction should be recorded: debit or credit.
2.4. Recording Business transaction in a Journal
Transactions recorded in the respective source document are first recorded chronologically in the book called
Journal. A journal is also called the book of original-entry, records the day to day business activities of the firm
in chronological order. It provides a complete record of all transactions in one place.
General journal is a two column type of journal used to record all types of transactions together. Thus, in a
general journal transactions are recorded chronologically indicating the dual effect of each transaction in to a
minimum of two financial statement accounts.
Special journal
Special journal is a type of journal into which one type of transaction is recorded. Special journal may be used,
instead of general journal, when many transactions of the same nature occur frequently. It is used as more
efficient means of recording and summarizing such recurring transactions. Use of special journal would
enable:
 To achieve division of labor
 To minimize errors
 To implement the system of internal control
 To record transaction in a manner that save both time and effort
 To facilitate posting by way of reducing the clerical work of posting from the journal to the ledger.
Common types of special journals include: Sales journal, purchase journal, cash receipt journal and cash
payment journal.
Example
Let’s try to see few transactions and their presentation in a general journal.
January 3, 2005. ABC Co. purchased supplies from XYZ for Birr 1,000 on account.
January 15, 2005. ABC Co. sold goods for Birr 6,500 cash. (The Co. uses periodic inventory system).
January 15, 2005. ABC Co. paid Birr 2,500 for advertisement.

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The journal is illustrated in the next page taking in to account the above transactions. If the transactions occur
in the same year or month and within the same page, there is no need to write again the year or month.
However, the specific day should be written for all transactions even if the transactions occur in the same day.
General Journal Page No….

Date Account Titles and Description P/R Debit Credit

2005
January 3 Supplies 1,000 00
Accounts Payable 1,000 00
(Purchased supplies on
account)

15 Cash 6,500 00
Sales Revenue 6,500 00
(To record cash sales)

15 Advertising Expense 2,500 00

Cash 2,500 00
(Paid advertising expense)

2.5. Classifying data by posting transactions from a journal to Ledger

The procedure of transferring journal entries to the ledger accounts is called posting. For each item (element)
that is to be presented in the financial statements, a separate record will be maintained. This record is called an
account. An account is used to summarize the effects of transactions on each element of the expanded
accounting equation. A ledger is a collection of all the accounts maintained by a business. It summarizes the
data in the journal bringing all the data of one kind together. Thus, ledger is considered as book of final entry.

General ledger: is a collection of complete set of accounts established by a specific firm. Accounts in the
general ledger are classified into five categories: assets, liabilities, owner’s equity, revenue and expenses.
These accounts are reported in the financial statements.

Classification of Ledger accounts

Ledger accounts are classified as permanent (real) and temporary (nominal) accounts.
 The permanent accounts are the asset, liability, and owners’ equity accounts whose balances at the
end of the accounting period are carried forward into the next accounting period.
 Temporary accounts On the other hand include revenue, expense, and drawing (dividend) accounts.
These accounts are ‘temporarily’ used to determine the changes in retained earnings that occur during
an accounting period, and their account balances are not carried forward into the next period.

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Subsidiary ledger:

Account in the general ledger contain only the major financial statement accounts of assets, liabilities, owner’s
equity, revenue and expenses being maintained in the summary form. Detail record for some of the general
ledger account is maintained in the separate ledger called subsidiary ledger. This helps to maintain detail
records regarding individual balances. Subsidiary ledger is a group of account with common characteristics
into which the greater detail for the particular general ledger account is maintained.

Example for general ledger and subsidiary ledger

General Ledger
Accounts Receivable
800
Accounts Receivable Subsidiary Ledger
Customer A Customer B Customer C
400 300 100

Posting involves transferring date, debit and credit amounts from the journal entries in the general journal to
the debit and credit sides of the accounts in the general ledger. The simplest form of an account is “T” account.
However, in the practical world, two forms of ledger accounts are commonly used: 2 amount column and 4
amount column. For our purpose we will illustrate 4 amount column form of an account.
General Ledger
Account: Supplies Account No. 15
Date Item P/R Debit Credit Balance
(Explanation) Debit Credi
t
2005
Jan. 1 Balance √ 250 00
5 GJ10 1,000 00 1,250 00

Account: Accounts Payable Account No. 21

Date Item P/R Debit Credit Balance
(Explanation) Debit Credit
2005
Jan. 5 GJ10 1,000 00 1,000 00

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Summarizing Phase

Once the recording phase is completed, the data must be summarized and organized into a useful format. The
remaining steps of the accounting process are designed to accomplish this purpose.

2.6. Preparing a trail balance

After all transactions for the period have been posted to the individual accounts in the ledger, the balance of
each account is determined. Every account will have either a debit, credit or zero balance. Now we can see the
importance of having the accounts. It would be difficult (if not impossible) to determine the balance of each
financial statement item directly from journal. Even though the transactions are already recorded in the journal,
posting should not be considered redundancy.

After determining the balance in each account, a trial balance is often prepared. A trail balance is a working
paper that lists all the company’s general ledger accounts and their account balances. The trial balance
indicates whether total debits equal total credits and thus provides a general check on the accuracy of recording
and posting.
If the two sides of the trial balance are not equal, it may be an indication for one or more of the following
errors:
a) Error in preparing the trial balance
b) Error in determining the account balance; or
c) Error in recording transaction in the ledger.
But, what you have to bear in your mind is that, equality of total debits and total credits in the trail balance is
not a complete proof of the accuracy. This is because there are errors which cannot be discovered by preparing
the trial balance. However, if a trial balance does not balance, clearly there is an error. To find the error, the
debit and credit columns of the trial balance should be added again. If the column totals do not agree, the
amounts in the debit and credit columns should be checked to be sure that a debit or credit account balance was
not mistakenly listed in the wrong column.

Basically there are two types of errors that are mostly committed i.e. transposition and slide error. A
transposition occurs when two digits in a number are mistakenly reversed. For instance, if a Birr 3,400 cash
balance is listed as Birr 4,300 on the trial balance or if a cash sale of Birr 6,500 is incorrectly recorded and
posted as Birr 5,600 to cash account, but correctly to sales. A slide occurs when the digits are listed in the
correct order but are mistakenly moved one decimal place to the left or right. For instance, if a Birr 1,250
accounts payable balance is listed as Birr 125 on the trial balance or if the payment of Birr 2,500 for

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advertising is correctly recorded and posted on a debit to advertising expense account for Birr 2,500 but
incorrectly recorded and posted as a credit to cash for Birr 25,000.
2.7. Preparing adjusting entries
At the end of each accounting period, some accounts do not show the up-to-date (current) balance. If we take
cash, it is continuously updated for receipts and payment throughout the accounting period and doesn’t require
period-end adjustment. However, if we come to prepaid rent or supplies, for example, the expired cost or
consumption, for that matter, will not be recorded on a day-to-day basis. This is done for practical reasons. As
a result the balance in these accounts is not timely adjusted and requires period-end adjustment. Adjusting
entries are journal entries made at the end of the accounting period to allocate revenue and expenses to the
period in which they actually are applicable so that the company’s financial statements include the correct
amount for the current period. Adjusting entries are required because normal journal entries are based on actual
transactions, and the date on which these transactions occur may not be the date required to fulfill the matching
principle of accrual accounting.

Every adjusting entry affects both a balance sheet (permanent) account and an income statement (temporary)
account. This characteristic of adjusting entries reflects the dual purpose of adjusting entries: i.e., to measure
all assets and liabilities accurately, and to measure net income correctly under the accrual basis of accounting.
Adjusting entries may be classified into three categories. These categories and the types of balance sheet
accounts involved in the adjusting entries are:

1.Apportionment of prepared and deferred items

a. prepaid expenses
b. deferred revenues
2. Recording of accrued items
a. Accrued expenses
b. Accrued revenues
3. Recording estimated items

A. Prepaid Expenses
These are payments made in advance (e.g., prepaid rent, prepaid insurance) or purchase of assets which are
going to be consumed or used up in the future (e.g. supplies).

In this case, the expiration of costs is the result of either passage of time or consumption of the resources.
Therefore, at the end of the period, it is necessary to determine the portion of such expenditures that are
applicable to subsequent periods.

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Prepayments can be recorded in two ways upon payments. Accordingly, the type of adjusting entry required at
the end of the period depends on the initial recording of the prepayments. There are two possibilities in relation
to the prepaid expenses at the time the transaction takes place. That is it could be recorded initially as an asset
or expense. The following table summarizes policies that may be adopted initially upon the cash payments, the
nature of adjusting entries required at the end of the period, and whether or not reversing entries are required at
the beginning of the next fiscal period.

Initial Recording Policy Adjustment Required at the end of Requirements for

the Period Reversing entries
Prepayments recorded initially as assets To record the expired portion as No Reversing entry is
(Balance sheet Approach) expense and reduce the related asset Required
account
Prepayments recorded initially as To record the unexpired portion as Reversing entry is
expense (Income statement Approach) assets and reduce the expense account Required
Example

On April 1, 2004, XYZ PLC has paid Br.12, 000 for the rent of the building that the company is occupying. If
this advance payment is for one year (until March 31,2005), record the adjusting entries required on December
31,2004, assuming that end of accounting period is Dec. 31.

i. Prepaid expenses initially recorded as assets

On April 1, 2004 Prepaid Rent 12,000

Cash 12,000

From April 1,2004 – December 31,2004, there are 9 months. Therefore, out of the total advance payment, the
rent expense for 2004 is only Birr 9,000 (9/12 * 12,000).

The adjusting entry on December 31,2004, therefore, will be

Dec. 31,2004 Rent Expense 9,000

Prepaid Rent 9,000

ii. Prepaid expenses initially recorded as expenses:

If, however, the advance payment is initially recorded as expense, the unexpired part should be transferred
from expense to asset account. The unexpired part is part of the advance payment that belongs to the future
(the first three months in 2005, i.e., January 1 – March 31, 2005).

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On April 1, 2004 Rent Expense 12,000
Cash 12,000
The adjusting entry as of December 31,2004 will be:

Dec. 31, 2004 Prepaid Rent 3,000

Rent Expense 3,000

B. Deferred Revenues (Unearned Revenue)

This refers to the amount which is collected from customers in advance for the future sale of inventory or
performance of service. Until the company delivers the goods or renders service, it remains liable. And similar
to the prepaid expenses, there are two approaches for initial recording of deferred revenues: initially as a
liability or as revenue.

Example

On September15,2005, Melhik Publishing Enterprise, publisher of Eftin Amharic newspaper, has received a
subscription fee of Birr 104,000 (i.e., 52 weekly issues X Birr 2 per copy X 1000 copies every week) from the
distributor in Mekelle for 52 weekly issues. In this case, we are assuming a single case where Melhik is going
to provide 1,000 copies each week from its weekly issue. Let’s assume that in 2005, Melhik has delivered to
the distributor in Mekelle 13 weekly issues (of 1000 copies each).

i. Deferred Revenues initially recorded as a liability

If advance collections are initially recorded as a liability, at the end of the accounting period, a portion of these
which is realized (earned) should be recognized.

At the time Melhik Publishing Entcollects money, the journal entry will be:

Sept.15,2005 Cash 104,000

Unearned Subscriptions Revenue 104,000

If the liability account was initially credited, the liability account will be debited and revenue account will be
credited for the amount of revenue earned in year 2005. Out of the total advance collection, Melhik Publishing
Enterprise earned Birr 26,000 only (i.e. 13 X 1,000 X Birr2). As a result, the adjusting entry will be:

Dec. 31, 2005 Unearned Subscriptions Revenue 26,000

Subscription Revenue 26,000

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ii. Deferred Revenue initially recorded as Revenue

If advance collections are initially recorded as revenue, at the end of the accounting period, the unearned part
should be transferred to the liability account. At the time, Melhik Publishing Enterprise collects money; the
transaction will be recorded as follows:

Sept. 15,2005 Cash 104,000

Subscriptions Revenue 104,000

At the end of the fiscal year, the adjusting entry will be:

Dec. 31, 2005 Subscriptions Revenue 78,000

Unearned Subscriptions Revenue 78,000

Whether the advance collection is initially recorded as a liability or revenue, the result is going to be the same
after the adjusting entries are recorded and posted.

In both cases, after adjusting entries are recorded and posted, the balances in Unearned Subscription Revenue
(liability) account and Subscriptions Revenue (Revenue) account will be Birr 78,000 and Birr 26,000
respectively.

C. Accrued Expenses (Accrual of Unrecorded Expenses)

The incurring of certain expenses is related to the passage to time. And such expenses are usually recorded
when payment is made, except when the end of the accounting period comes before the required day of
payment. These expenses although incurred, their payment will take place in subsequent period. Expenses that
are incurred during the accounting period but neither paid nor recorded are called accrued expenses. In order
to match expenses against revenues and to reflect the proper liabilities at the end of the period an adjusting
entry must be made for each accrued expense. Typical examples of accrued expenses are salary and interest
expense.
Example
Satcon Construction Co. pays wages to the daily laborers every Friday. That is, wage for 5 working days in a
week (from Monday to Friday) will be paid on Friday. If December 31, 2003 was on Wednesday, the company
has to update its accounts as of this date in order to properly match revenue with expenses.

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 Fr. Sa. Su Mo. Tu Wed Th Fr Sa days
Dec. 26 27 28 29 30 31 Jan. 1 2 3

3 days 2 days
Year 2003 Year 2004
Every Friday, Satcon Construction Co. pays Birr 80,000. The last payment in the year 2003 was made on Dec.
26. The next payment will be made on January 2, 2004. The payment made on January 2 will therefore be for
wages incurred in the last 3 days in year 2003 and the first 2 days in year 2004. Therefore, for proper matching
of revenue and expense, on December 31, 2003 (before date of payment) the accrued expense has to be
recorded. The average daily wage is Birr 16,000 (i.e., Birr 80,000 ÷ 5 days). Therefore as of December 31,
2003, Satcon Construction Co. has incurred 3 days wage of Birr 48,000 (3 X 16,000). This will be recorded as
follows:

Dec. 31, 2003 Wages Expense 48,000

Wages Payable 48,000

The same will be true for all other expenses incurred but not paid and recorded.

D. Accrued Revenue (Accrual of Unrecorded Revenue)

At the end of an accounting period, a company might have an amount earned which is expected to be collected
in the following accounting period. Revenue of this type that the company has earned during the accounting
period but has neither received nor recorded is called accrued revenue.

Example
On October 1, 2004, Satcon Construction Co. deposited Birr 1,000,000 in Commercial Bank of Ethiopia
(CBE). Let’s assume CBE pays interest every six months period on April 1 and October 1. The interest rate is
3% per year.

Satcon Construction Co. will collect interest for the first six months on April 1, 2005. The interest collected on
April 1, 2005 will be for 3 months in year 2004 and 3 more months in year 2005. At the end of December
2004, the accounting records of Satcon Construction Co. should be updated, and the accrued interest for 3
months (Oct. 1, 2004 – Dec. 31, 2004) will be determined as follows:

Interest = Principal X Rate X Time

= Birr 1,000,000 X 3% X 3/12

= Birr 7,500

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The journal entry made by Satcon Construction Co. to record the interest revenue earned but not received will
be a debit to Interest Receivable (Asset) account and a credit to Interest Revenue (Revenue) account for Birr
7,500.

Dec. 31, 2004 Interest Receivable 7,500

Interest Revenue 7,500

e. Recording Estimated Items

All adjusting entries could not be based on actual data. That is, some of the adjusting entries at the end of the
period require estimates. This is because they are at least partly the function of expected future events. Yearend
adjustments for depreciation of plant assets and bad debts expense require estimation.

i. Asset Depreciation

Plant assets such as building and machinery are useful in the operation of companies. The usefulness of these
assets normally declines as a result of usage or passage to time. This decline in usefulness should be
accompanied by a systematic transfer of expired costs for proper matching.

In recording plant asset depreciation, Depreciation Expense account is debited and a credit will be to
Accumulated Depreciation account (a contra asset account). The amount of depreciation is based on the actual
acquisition cost and estimates for useful life and salvage value. Different depreciation methods could be used
to determine periodic depreciation expense. Depreciation expense is usually recorded at the end of the fiscal
period. However, the expense for a partial period may be recorded if there is disposal of plant asset before the
end of period.

Example

Based on Straight line method, ABC Trading estimated that depreciation expense on Building for the year
ended December 31, 2004 is Birr 125,000.

The following entry is then made:

Dec. 31, 2004 Depreciation Expense – Building 125,000

Accumulated Depreciation – Building 125,000

ii. Valuation of Accounts Receivable

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When a business sells goods or services on account, some of the accounts receivable will prove to be
uncollectible, resulting in bad debts expense. Under accrual basis of accounting, an adjustment will be required
for the estimated bad debts expense in the period in which the credit sales actually takes place rather than the
period in which they actually become uncollectible. This produces a better matching of revenues and expenses
and therefore, a better income measurement. The adjusting entry will be a debit to Bad Debts Expense and a
credit to Allowance for Doubtful Accounts (a contra asset account).

Example

ABC Co.’s credit sales for the year ended December 31, 2004 was Birr 2,000,000. If bad debts expense is
estimated to be 1% of total credit sales, the adjusting entry at the end of the year will be:

Dec. 31, 2004 Dad Debts Expense 20,000

Allowance for Doubtful Accounts 20,000

2.8. Preparing Financial Statements

After the accounts are brought up to date, financial statements may be prepared. The data for preparing the
financial statements may be taken directly from the adjusted accounts in the ledger and /or a work sheet may be
used. Preparing a worksheet is an optional step to facilitate the preparation of the financial statements.
Worksheet is a working paper. It is an informal record prepared by accountants for their own use and is not
part of the permanent records such as journal, ledger and financial statements.
2.9. Preparing Closing Entries
As we have tried to see it in the classification of ledger, accounts in the ledger can be classified broadly in to
two as Real (permanent) and Nominal (temporary). Real accounts are accounts whose balance is transferred
(carried forward) from period to period. For example, the balance in asset, liability and owners’ equity
accounts will be transferred from period to period. On the other hand the balance in the temporary accounts
will not be transferred from period to period. For example, if we take salary expense account, the account is
opened in order to determine salary expense for each period. At the end of each period, once the salary expense
for that period is known, the purpose for maintaining salary expense account is accomplished. As a result the
balance in this account should be transferred to another account and this is called closing process. At the end of
each accounting period, after the financial statements are prepared, all temporary accounts will be closed.
The purpose of the closing process is two-fold:
1) Closing is a mechanism to update the retained earnings account (if the company is Corporation) or
Capital accounts (in Sole-proprietorship and Partnership form of businesses) in the ledger to equal the
end-of-period balance. Keep in mind the recording of each item of revenue, expense, or dividend does

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 not automatically produce an updating debit or credit to retained earnings or capital accounts.  As such,
the beginning-of-period retained earnings or beginning-of-period capital account(s) amount remains in
the ledger until the closing process "updates" the retained earnings or capital account for the impact of
the period's operations.
2) Revenue, expense, and dividend/drawing accounts represent amounts for a period of time; one must
bring these accounts to zero at the end of each period (as a result, revenue, expense, and dividend or
drawing accounts are called temporary or nominal accounts). In essence, by bringing these accounts to
zero balance, one has reset them to begin the next accounting period.  In contrast, asset, liability, and
equity accounts are called real accounts, as their balances are carried forward from period to period. For
example, one does not "start over" each period accumulating asset like cash and so on -- their balances
carry forward.

Closing involves a four step process: (a) close revenue accounts and other accounts with credit balances (to a
unique account called Income and Expense Summary -- a non-financial statement account used only to
facilitate the closing process), (b) close expense and other accounts with debit balances to Income and Expense
Summary, (c) close the Income and Expense Summary account to Retained Earnings or Capital account(s), and
(d) close the Dividend or Drawing account to Retained Earnings or Capital account(s).  By doing this, all
revenues and expenses are brought in to one (summarized) in Income and Expense Summary (the net of which
represents the income or loss for the period).  In turn, the income or loss is then swept to Retained Earnings or
Capital accounts along with the dividends.  Recall that beginning retained earnings or capital, plus net income,
less dividends, equals ending retained earnings or capital; likewise, the closing process updates the beginning
retained earnings or capital to move forward to the end-of-period balance.

Assuming that the company uses perpetual inventory system, the closing entries at the end of the period may
include the following:

Sales XXX
Other Revenues XXX
Income & Expense Summary XXX

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Income & Expense Summary XXX
Cost of Goods Sold XXX
Salaries and Wages Exp. XXX
Depreciation Exp. XXX
Bad Debts Exp. XXX
Miscellaneous Exp. XXX
Other Expenses XXX
The balance in Income and Expense Summary account will be closed to Retained Earnings account if it is
corporation, or to Owners’ Equity account(s) in case of sole proprietorship and partnership.

Assuming that there is net income, i.e. the Income and Expense Summary account has a credit balance, the
closing entry will be:

Income & Expense Summary XXX

Retained Earnings (Capital account) XXX
Dividend or drawing account is closed to Retained Earning or capital accounts depending on the type of
ownership.
Retained Earnings (Capital) XXX
Dividend (Drawing) XXX
2.10. Preparing Post-Closing Trial Balance

After all temporary accounts are closed; a trial balance may be prepared for real accounts only, in order to
prove the equality of the total debits and credits in the ledger.
2.11. Reversing Entries
Reversing entries are optional entries and may be made on the first day of the next accounting period.
Reversing entries, although they are optional accounting procedure, may prove useful in simplifying record
keeping. A reversing entry is a journal entry to "undo" an adjusting entry. Revering entry is the exact reverse of
adjusting entry. The reversing entries make it possible to record the expense payments or revenue receipts in
the new period in the usual manner. If a company adopts the policy of having reversing entries at the beginning
of each year, reversing will be made for:
1. all accruals
- accrued expenses
- accrued revenue
2. for deferrals
- Deferred (prepaid) expenses initially recorded as expense only.

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 - Deferred revenue (advance collection) initially recorded as revenue only.
Or, reversing entry could be made when an adjusting entry creates an asset or a liability account which
normally is not used during the accounting period.

Example
In relation to accrued expense, one example was given on accrued wages expense.
Every Friday, Satcon Construction Co. pays Birr 80,000 in the form of wages for each week. At the time of
payment, the journal entry is:

Wages Expense 80,000

Cash 80,000
We assumed that end of accounting period, Dec. 31, 2003, was on Wednesday. At that time the adjusting entry
was:

Dec. 31, 2003 Wages Expense 48,000

Wages Payable 48,000
When payment is made (if no reversing entry is made) the entry to pay wages to employees will be:

January 2, 2004 Wages Expense 32,000

Wages Payable 48,000
Cash 80,000
On the other hand if the company records reversing entries at the beginning of each period, the reversing entry
on January 1, 2004 will be presented as follows:

Jan. 1, 2004 Wages Payable 48,000

Wages Expense 48,000
On Dec. 31, 2004, all expenses will be closed and will then have zero balance. After reversing entries are
recorded and posted on January 1, 2004, the Wages Expense account will have credit balance of Birr 48,000.
The nature of this amount will not be changed and is still liability to the company. And on Jan. 2, 2005, when
the company pays wages the entry will be:

Jan.2, 2004 Wages Expense 80,000

Cash 80,000 (as usual)
After this entry is recorded and posted, wages expense account will show debit balance of Birr 32,000
representing expense related to year 2004.

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