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In Chapter 1, we illustrated the income statement, statement of retained earnings, balancesheet, and statement of cash flows. These statements are the end products of the financialaccounting process, which is based on the accounting equation. The financial accountingprocess quantifies past management decisions. The results of these decisions arecommunicated to users—management, creditors, and investors—and serve as a basisfor making future decisions.The raw data of accounting are the business transactions. We recorded thetransactions in Chapter 1 as increases or decreases in the assets, liabilities, andstockholders’ equity items of the accounting equation. This procedure showed you howvarious transactions affected the accounting equation. When working through thesesample transactions, you probably suspected that listing all transactions as increases ordecreases in the transactions summary columns would be too cumbersome in practice.Most businesses, even small ones, enter into many transactions every day. Chapter 2teaches you how to actually record business transactions in the accounting process.To explain the dual procedure of recording business transactions with debitsand credits, we introduce you to some new tools: the T-account, the journal, and the ledger.Using these tools, you can follow a company through its various business transactions.Like accountants, you can use a trial balance to check the equality of your recordeddebits and credits. This is the double-entry accounting system that the Franciscan monk,Luca Pacioli, described centuries ago. Understanding this system enables you to betterunderstand the content of financial statements so you can use the information providedto make informed business decisions.The Account and Rules of Debit and CreditA business may engage in thousands of transactions during a year. An accountantclassifies and summarizes the data in these transactions to create useful information.1.1.Use the account as thebasic classifying andstorage unit foraccounting information.18.104.22.168.Express the effects ofbusiness transactions interms of debits andcredits to differenttypes of accounts.22.214.171.124.List the steps in theaccounting cycle.126.96.36.199.Record the effects ofbusiness transactions ina journal.5.5.Post journal entries tothe accounts in theledger.(continued)
5050PART II Processing Information for Decisions and Establishing Accounting PolicyAn AccountingAn AccountingPerspectivePerspectiveSteps in Recording Business TransactionsLook at Illustration 2.1 to see the steps in recording and posting the effects of abusiness transaction. Note that source documents provide the evidence that a businesstransaction occurred. These source documents include such items as bills receivedfrom suppliers for goods or services received, bills sent to customers for goods soldor services performed, and cash register tapes. The information in the source documentserves as the basis for preparing a journal entry. Then a firm posts (transfers) thatinformation to accounts in the ledger.You can see from Illustration 2.1 that after you prepare the journal entry, youpost it to the accounts in the ledger. However, before you can record the journal entry,you must understand the rules of debit and credit. To teach you these rules, we beginby studying the nature of an account.Fortunately, most business transactions are repetitive. This makes the task of accountantssomewhat easier because they can classify the transactions into groups having commoncharacteristics. For example, a company may have thousands of receipts or paymentsof cash during a year. As a result, a part of every cash transaction can be recorded andsummarized in a single place called an account.An account is a part of the accounting system used to classify and summarizethe increases, decreases, and balances of each asset, liability, stockholders’ equityitem, dividend, revenue, and expense. Firms set up accounts for each different businesselement, such as cash, accounts receivable, and accounts payable. Every business hasa Cash account in its accounting system because knowledge of the amount of cash onhand is useful information.Accountants may differ on the account title (or name) they give the sameitem. For example, one accountant might name an account Notes Payable and anothermight call it Loans Payable. Both account titles refer to the amounts borrowed by thecompany. The account title should be logical to help the accountant group similartransactions into the same account. Once you give an account a title, you must use thatsame title throughout the accounting records.The number of accounts in a company’s accounting system depends on theinformation needs of those interested in the business. The main requirement is thateach account provides information useful in making decisions. Thus, one account maybe set up for all cash rather than having a separate account for each form of cash(coins on hand, currency on hand, and deposits in banks). The amount of cash isuseful information; the form of cash often is not.To illustrate recording the increases and decreases in an account, texts use the T-account,which looks like a capital letter T. The name of the account, such as Cash, appearsacross the top of the T. We record increases on one side of the vertical line of the T anddecreases on the other side. A T-account appears as follows:Title of AccountBusiness Insight Business Insight Have you ever considered starting your own business? If so, you’llneed to understand accounting to successfully run your business. To know how wellyour business is doing, you must understand and analyze financial statements.Accounting information also tells you why you are performing as reported. If you arein business to sell or develop a certain product or perform a specific service, youcannot operate profitably or consider expanding unless you base your business decisionson accounting information.Note to the StudentGive an example of abusiness you would like tostart or in which you arepresently working. Developtypical transactions of thebusiness and analyze thesetransactions.The T-AccountObjectives6.Prepare a trialbalance to test theequality of debits andcredits in thejournalizing andposting process.7.Analyze and use thefinancial results—horizontal and verticalanalyses.Objective 1Use the account as the basicclassifying and storage unitfor accounting information.The Account
51CHAPTER 2 Recording Business TransactionsIn Chapter 1, you saw that each business transaction affects at least twoitems. For example, if you—an owner—invest cash in your business, the company’sassets increase and its stockholders’ equity increases. This result was illustrated in thesummary of transactions in Illustration 1.3. In the following sections, we use debitsand credits and the double-entry procedure to record the increases and decreasescaused by business transactions.Accountants use the term debitinstead of saying, “Place an entry on the left side of theT-account.” They use the term creditfor “Place an entry on the right side of the T-account.” Debit (abbreviated Dr.) simply means left side; credit (abbreviated Cr.) meansright side.1Thus, for all accounts a debit entry is an entry on the left side, while a creditentry is an entry on the right side.Any AccountLeft, orRight, ordebit, sidecredit, sideAfter recognizing a business event as a business transaction, we analyze it to determineits increase or decrease effects on the assets, liabilities, stockholders’ equity items,dividends, revenues, or expenses of the business. Then we translate these increase ordecrease effects into debits and credits.In each business transaction we record, the total dollar amount of debits mustequal the total dollar amount of credits. When we debit one account (or accounts) for$100, we must credit another account (or accounts) for a total of $100. The accountingrequirement that each transaction be recorded by an entry that has equal debits andcredits is called double-entry procedure, or duality.This double-entry procedurekeeps the accounting equation in balance.The dual recording process produces two sets of accounts—those with debitbalances and those with credit balances. The totals of these two groups of accountsmust be equal. Then, some assurance exists that the arithmetic part of the transactionrecording process has been properly carried out. Now, let us actually record businesstransactions in T-accounts using debits and credits.Recording Changes in Assets, Liabilities, and Stockholders’ EquityWhile recording business transactions, remember that the foundation of the accountingprocess is the following basic accounting equation:Assets = Liabilities + Stockholders’ EquityRecording transactions into the T-accounts is easier when you focus on theequal sign in the accounting equation. Assets, which are on the left of the equal sign,Debits and CreditsNote to the StudentDebit and credit aredirectional signals. Thelimited meaning of debit is torecord the amount on theleft side of the account; thelimited meaning of credit is torecord the amount on theright side of the account.Illustration 2.1 The Steps in Recording and Posting the Effects of a Business TransactionDouble-EntryProcedureObjective 2Express the effects ofbusiness transactions interms of debits and credits todifferent types of accounts.The company enters into business transactionas the result of a management decisionThe company transaction is evidenced by a source documentThe source document serves as the basis for preparing a journal entryThe journal entry is posted to the accounts in the ledger1The abbreviations “Dr.” and “Cr.” are based on the Latin words “debere” and “credere.” A synonym for debit an account ischarge an account.
5252PART II Processing Information for Decisions and Establishing Accounting Policyincrease on the left side of the T-accounts. Liabilities and stockholders’ equity, to theright of the equal sign, increase on the right side of the T-accounts. You already knowthat the left side of the T-account is the debit side and the right side is the credit side.So you should be able to fill in the rest of the rules of increases and decreases bydeduction, such as:Assets=Liabilities+Stockholders’ EquityDebit forincreasesCredit fordecreasesDebit fordecreasesCredit forincreasesDebit fordecreasesCredit forincreasesTo summarize:1.Assets increase by debits (left side) to the T-account and decrease by credits(right side) to the T-account.2.Liabilities and stockholders’ equity decrease by debits (left side) to the T-accountand increase by credits (right side) to the T-account.Applying these two rules keeps the accounting equation in balance. Now we apply thedebit and credit rules for assets, liabilities, and stockholders’ equity to businesstransactions.Assume a corporation issues shares of its capital stock for $10,000 in transac-tion 1. (Note the figure in parentheses is the number of the transaction and ties the twosides of the transaction together.) The company records the receipt of $10,000 asfollows:(Dr.)Cash(Cr.)(Dr.)Capital Stock(Cr(1)10,000(1)10,00This transaction increases the asset, cash, which is recorded on the left side of theCash account. Then, the transaction increases stockholders’ equity, which is recordedon the right side of the Capital Stock account.Assume the company borrowed $5,000 from a bank on a note (transaction 2).A noteis an unconditional written promise to pay to another party (the bank) theamount owed either when demanded or at a specified date, usually with interest at aspecified rate. The firm records this transaction as follows:(Dr.)Cash(Cr.)(Dr.)Notes Payable(Cr.)(1)10,000(2)5,000(2)5,000Observe that liabilities, Notes Payable, increase with an entry on the right (credit) sideof the account.Recording Changes in Revenues and Expenses In Chapter 1, we recordedthe revenues and expenses directly in the Retained Earnings account. However, this isnot done in practice because of the volume of revenue and expense transactions.Instead, businesses treat the expense accounts as if they were subclassifications of thedebit side of the Retained Earnings account, and the revenue accounts as if they weresubclassifications of the credit side. Since firms need the amounts of revenues andexpenses to prepare the income statement, they keep a separate account for each typeof revenue and expense. The recording rules for revenues and expenses are:Reinforcing ProblemReinforcing ProblemE2–1 Indicate rules of debitand credit.Real World ExampleAetna Inc., the largest U.S.health insurer, announced onDecember 13, 2001 that itplanned to cut about 6,000jobs, eliminating nearly asixth of its work force. Howwould this event impact thefinancial statements?Reinforcing ProblemE2–6 Explain sets of debitsand credits.
53CHAPTER 2 Recording Business Transactions·Record increases in revenues on the right (credit) side of the T-account anddecreases on the left (debit) side. The reasoning behind this rule is that revenuesincrease retained earnings, and increases in retained earnings are recorded on theright side.·Record increases in expenses on the left (debit) side of the T-account anddecreases on the right (credit) side. The reasoning behind this rule is that expensesdecrease retained earnings, and decreases in retained earnings are recorded on theleft side.To illustrate these rules, assume the same company received $1,000 cashfrom a customer for services rendered (transaction 3). The Cash account, an asset,increases on the left (debit) side of the T-account; and the Service Revenue account,an increase in retained earnings, increases on the right (credit) side.Now assume this company paid $600 in salaries to employees (transaction 4).The Cash account, an asset, decreases on the right (credit) side of the T-account; andthe Salaries Expense account, a decrease in retained earnings, increases on the left(debit) side.2Recording Changes in Dividends Since dividends decrease retained earnings,increases appear on the left side of the Dividends account and decreases on the rightside. Thus, the firm records payment of a $2,000 cash dividend (transaction 5) asfollows:At the end of the accounting period, the accountant transfers anybalances in the expense, revenue, and Dividends accounts to the Retained Earningsaccount. This transfer occurs only after the information in the expense and revenueaccounts has been used to prepare the income statement. We discuss and illustrate thisstep in Chapter 4.To determine the balance of any T-account, total the debits to the account, total thecredits to the account, and subtract the smaller sum from the larger. If the sum of thedebits exceeds the sum of the credits, the account has a debit balance. For example,the following Cash account uses information from the preceding transactions. Theaccount has a debit balance of $13,400, computed as total debits of $16,000 less totalcredits of $2,600.(Dr.)Cash(Cr.)(Dr.)Dividends3(Cr.)(1)10,000(4)600(5)2,000(2)5,000(5)2,000(3)1,000(Dr.)Cash(Cr.)(Dr.)Salaries Expense(Cr.)(1)10,000(4)600(4)600(2)5,000(3)1,000(Dr.)Cash(Cr.)(Dr.)Service Revenue(Cr.)(1)10,000(3)1,000(2)5,000(3)1,000Determining theBalance of anAccount2Certain deductions are normally taken out of employees’ pay for social security taxes, federal and state withholding, and so on.Those deductions are ignored here.3As we illustrate later in the text, some companies debit dividends directly to the Retained Earnings account rather than to aDividends account.
5454PART II Processing Information for Decisions and Establishing Accounting Policy(Dr.)Cash(Cr.)(1) 10,000(4) 600(2)5,000(5)2,000(3)1,00016,0002,600Dr. bal13,400If, on the other hand, the sum of the credits exceeds the sum of the debits, the accounthas a credit balance. For instance, assume that a company has an Accounts Payableaccount with a total of $10,000 in debits and $13,000 in credits. The account has acredit balance of $3,000, as shown in the following T-account:(Dr.)Accounts Payable(Cr.)10,0007,0006,00010,00013,000Cr. bal3,000Normal Balances Since debits increase asset, expense, and Dividend accounts,they normally have debit (or left-side) balances. Conversely, because credits increaseliability, capital stock, retained earnings, and revenue accounts, they normally havecredit (or right-side) balances.The following chart shows the normal balances of the seven accounts wehave used:Normal BalancesTypes of AccountsDebit CreditAssetsXLiabilitiesXStockholders’ EquityCapital StockXRetained earningsXDividendsXExpensesXRevenuesXAt this point, you should memorize the six rules of debit and credit. Later, as youproceed in your study of accounting, the rules will become automatic. Then, you willno longer ask yourself, “Is this increase a debit or credit?”Asset accounts increase on the debit side, while liability and stockholders’equity accounts increase on the credit side. When the account balances are totaled,they conform to the following independent equations:Assets = Liabilities + Stockholders’ EquityDebits = CreditsThe arrangement of these two formulas gives the first three rules of debit andcredit:1.Increases in asset accounts are debits; decreases are credits.2.Decreases in liability accounts are debits; increases are credits.3.Decreases in stockholders’ equity accounts are debits; increases are credits.Rules of Debit andCredit Summarized
55CHAPTER 2 Recording Business TransactionsAsset Accounts=Liability Accounts+Stockholders’ Equity Account(s)(Capital Stock and Retained Earnings)Debit*CreditDebitCredit*DebitCredit*+Debitforincrease–Creditfordecrease–Debitfordecrease+Creditforincrease–Debitfordecrease+CreditforincreaseDebitsCreditsExpense Accountsand Dividends AccountRevenue Accounts1.Increase assets.1.Decreases assets.Debit*CreditDebitCredit*2.Decrease liabilities.2.Increase liabilities.3. Decreasestockholders’ equity.3. Increasestockholders’ equity.4.Decrease revenues.4.Increase revenues.5.Increase expenses.5.Decrease expenses.6.Increase dividends.6.Decrease dividends.+Debitforincrease–Creditfordecrease–Debitfordecrease+Creditforincrease* Normal balanceObjective 3List the steps in theaccounting cycle.Illustration 2.2 Rules of Debit and CreditThe debit and credit rules for expense and Dividends accounts and for revenueaccounts follow logically if you remember that expenses and dividends are decreases instockholders’ equity and revenues are increases in stockholders’ equity. Since stockholders’equity accounts decrease on the debit side, expense and Dividend accounts increase onthe debit side. Since stockholders’ equity accounts increase on the credit side, revenueaccounts increase on the credit side. The last three debit and credit rules are:4.Decreases in revenue accounts are debits; increases are credits.5.Increases in expense accounts are debits; decreases are credits.6.Increases in Dividends accounts are debits; decreases are credits.In Illustration 2.2, we depict these six rules of debit and credit. Note first thetreatment of expense and Dividends accounts as if they were subclassifications of thedebit side of the Retained Earnings account. Second, note the treatment of the revenueaccounts as if they were subclassifications of the credit side of the Retained Earningsaccount. Next, we discuss the accounting cycle and indicate where steps in theaccounting cycle are discussed in Chapters 2 through 4.The Accounting CycleThe accounting cycle is a series of steps performed during the accounting period(some throughout the period and some at the end) to analyze, record, classify, summarize,and report useful financial information for the purpose of preparing financial statements.Before you can visualize the eight steps in the accounting cycle, you must be able torecognize a business transaction. Business transactionsare measurable events thataffect the financial condition of a business. For example, assume that the owner of abusiness spilled a pot of coffee in her office or broke her leg while skiing. These twoevents may briefly interrupt the operation of the business. However, they are notmeasurable in terms that affect the solvency and profitability of the business.Business transactions can be the exchange of goods for cash between thebusiness and an external party, such as the sale of a book, or they can involve payingAssetsLiabilitiesStockholder’s Equity=+
5656PART II Processing Information for Decisions and Establishing Accounting Policysalaries to employees. These events have one fundamental criterion: They must havecaused a measurable change in the amounts in the accounting equation, Assets =Liabilities + Stockholders’ Equity. The evidence that a business event has occurred is asource document such as a sales ticket, check, and so on. Source documents are importantbecause they are the ultimate proof of business transactions.4After you have determined that an event is a measurable business transactionand have adequate proof of this transaction, mentally analyze the transaction’s effectson the accounting equation. You learned how to do this in Chapter 1. This chapter andChapters 3 and 4 describe the other steps in the accounting cycle. The eight steps inthe accounting cycle and the chapters that discuss them are:1.Analyze transactions by examining source documents (Chapters 1 and 2).2.Journalize transactions in the journal (Chapter 2).3.Post journal entries to the accounts in the ledger (Chapter 2).4.Prepare a trial balance of the accounts (Chapter 2) and complete the work sheet(Chapter 4). (This step includes adjusting entries from Chapter 3.)5.Prepare financial statements (Chapter 4).6.Journalize and post adjusting entries (Chapters 3 and 4).7.Journalize and post closing entries (Chapter 4).8.Prepare a post-closing trial balance (Chapter 4).This listing serves as a preview of what you will study in Chapters 2–4.Notice that firms perform the last five steps at the end of the accounting period. Step5 precedes steps 6 and 7 because management needs the financial statements at theearliest possible date. After the statements have been delivered to management, theadjusting and closing entries can be journalized and posted. In Illustration 2.3, wediagram the eight steps in the accounting cycle.You can perform many of these steps on a computer with an accountingsoftware package. However, you must understand a manual accounting system and allof the steps in the accounting cycle to understand what the computer is doing. Thisunderstanding removes the mystery of what the computer is doing when it takes inraw data and produces financial statements.The JournalIn explaining the rules of debit and credit, we recorded transactions directly in the accounts.Each ledger (general ledger) account shows only the increases and decreases in that account.Thus, all the effects of a single business transaction would not appear in any one account.For example, the Cash account contains only data on changes in cash and does not showhow the cash was generated or how it was spent. To have a permanent record of an entiretransaction, the accountant uses a book or record known as a journal.A journal is a chronological (arranged in order of time) record of businesstransactions. A journal entry is the recording of a business transaction in the journal. Ajournal entry shows all the effects of a business transaction as expressed in debit(s) andcredit(s) and may include an explanation of the transaction. A transaction is entered in ajournal before it is entered in ledger accounts.Because each transaction is initially recordedin a journal rather than directly in the ledger, a journal is called a book of original entry.A business usually has more than one journal. Chapter 4 briefly describes severalspecial journals. In this chapter, we use the basic form of journal, the general journal.As shown in Illustration 2.4, a general journal contains the following columns:Performed only at end ofthe accounting period.Performed throughout theaccounting periodObjective 4Record the effects ofbusiness transactions in ajournal.The General Journal4Many companies send and receive source documents electronically, rather than on paper. In such an electronic computerenvironment, source documents might exist only in the computer databases of the two parties involved in the transaction.
57CHAPTER 2 Recording Business TransactionsIllustration 2.3 Steps in the Accounting Cycle1.Date column.The first column on each journal page is for the date. For the firstjournal entry on a page, this column contains the year, month, and day (number).For all other journal entries on a page, this column contains only the day of themonth, until the month changes.2.Account Titles and Explanation column.The first line of an entry shows theaccount debited. The second line shows the account credited. Notice that weindent the credit account title to the right. For instance, in Illustration 2.4 weshow the debit to the Cash account and then the credit to the Capital Stockaccount. Any necessary explanation of a transaction appears on the line(s) belowthe credit entry and is indented halfway between the accounts debited andcredited. A journal entry explanation should be concise and yet complete enoughIllustration 2.4General JournalMICROTRAIN COMPANYGeneral JournalDateAccount Titles and ExplanationPost.Ref.DebitCredit2007Nov.28 Cash1005 0 0 0 0Capital Stock3005 0 0 0 0Stockholders invested $50,000 cash in business.Reinforcing ProblemsReinforcing ProblemsE2–2 Prepare journal entriesE2–3 Prepare journal entries
5858PART II Processing Information for Decisions and Establishing Accounting PolicyAn AccountingAn AccountingAn AccountingAn Accountingto describe fully the transaction and prove the entry’s accuracy. When a journalentry is self-explanatory, we omit the explanation.3.Posting Reference column.This column shows the account number of thedebited or credited account. For instance, in Illustration 2.4, the number 100 inthe first entry means that the Cash account number is 100. No number appears inthis column until the information has been posted to the appropriate ledgeraccount. We discuss posting later in the chapter.4.Debit column.In the debit column, the amount of the debit is on the same lineas the title of the account debited.5.Credit column.In the credit column, the amount of the credit is on the sameline as the title of the account credited.Uses of Technology Uses of Technology Preparing journal entries in a computerized system is differentthan in a manual system. The computer normally asks for the number of the account tobe debited. After you type the account number, the computer shows the account title inits proper position. The cursor then moves to the debit column and waits for you to enterthe amount of the debit. Then it asks if there are more debits. If not, the computerprompts you for the account number of the credit. After you type the account number, thecomputer supplies the account name of the credit and enters the same amount debitedas the credit. When there is more than one credit, you can override the amount and enterthe correct amount. Then you would enter the other credit in the same way. If your debitsand credits are not equal, the computer warns you and makes you correct the error. Youcan supply an explanation for the entry from a standard list or type it in. As you enter thejournal entries, the computer automatically posts them to the ledger accounts. At anytime, you can have the computer print a trial balance.A summary of the functions and advantages of using a journal follows:The journal—1.Records transactions in chronological order.2.Shows the analysis of each transaction in debits and credits.3.Supplies an explanation of each transaction when necessary.4.Serves as a source for future reference to accounting transactions.5.Eliminates the need for lengthy explanations from the accounts.6.Makes possible posting to the ledger at convenient times.7.Assists in maintaining the ledger in balance because the debit(s) must always equalthe credit(s) in each journal entry.8.Aids in tracing errors when the ledger is not in balance.The LedgerA ledger(general ledger) is the complete collection of all the accounts of a company.The ledger may be in loose-leaf form, in a bound volume, or in computer memory.Accounts fall into two general groups: (1) balance sheet accounts (assets,liabilities, and stockholders’ equity) and (2) income statement accounts (revenues andexpenses). The terms real accounts and permanent accounts also refer to balance sheetaccounts. Balance sheet accounts are real accountsbecause they are notsubclassifications or subdivisions of any other account. They are permanent accountsbecause their balances are not transferred (or closed) to any other account at the endof the accounting period. Income statement accounts and the Dividends account arenominal accountsbecause they are merely subclassifications of the stockholders’equity accounts. Nominal literally means “in name only.” Nominal accounts are alsocalled temporary accountsbecause they temporarily contain revenue, expense, andReinforcing ProblemP2–1A Prepare journalentries.Functions andAdvantages ofa Journal
59CHAPTER 2 Recording Business TransactionsAcct. Account TitleDescriptionNo.100CashBank deposits and cash on hand.103Accounts ReceivableAmounts owed to the company by customers.107Supplies on HandItems such as paper, envelopes, writing materials,and other materials used in performing trainingservices for customers or in doing administrativeAssetsand clerical office work.108Prepaid InsuranceInsurance policy premiums paid in advance of theperiods for which the insurance coverage applies.112Prepaid RentRent paid in advance of the periods for which therent payment applies.150TrucksTrucks used to transport personnel and trainingsupplies to clients’ locations.200Accounts PayableAmounts owed to creditors for items purchasedfrom them.216Unearned Service FeesAmounts received from customers before thetraining services have been performedfor them.Stockholders’300Capital StockThe stockholders’ investment in the business.equity310Retained EarningsThe earnings retained in the business.Dividends320DividendsThe amount of dividends declared to stockholders.Revenues400Service RevenueAmounts earned by performing training servicesfor customers.505Advertising ExpenseThe cost of advertising incurred in the current period.506Gas and Oil ExpenseThe cost of gas and oil used in trucks in theExpensescurrent period.507Salaries ExpenseThe amount of salaries incurred in the current period.511Utilities ExpenseThe cost of utilities incurred in the current period.dividend information that is transferred (or closed) to the Retained Earnings account atthe end of the accounting period.The chart of accountsis a complete listing of the titles and numbers of allthe accounts in the ledger. The chart of accounts can be compared to a table of contents.The groups of accounts usually appear in this order: assets, liabilities, stockholders’equity, dividends, revenues, and expenses.Individual accounts are in sequence in the ledger. Each account typically hasan identification number and a title to help locate accounts when recording data.For example, a company might number asset accounts, 100–199; liability accounts,200–299; stockholders’ equity accounts and Dividends account, 300–399; revenueaccounts, 400–499; and expense accounts, 500–599. We use this numbering systemin this text. The uniform chart of accounts used in the first 11 chapters appears in aseparate file at the end of the text. You should print that file and keep it handy forworking certain problems and exercises. Companies may use other numberingsystems. For instance, sometimes a company numbers its accounts in sequence startingwith 1, 2, and so on. The important idea is that companies use some numbering system.Now that you understand how to record debits and credits in an account and howall accounts together form a ledger, you are ready to study the accounting process in operation.The Accounting Process in OperationMicroTrain Company is a small corporation that provides on-site microcomputersoftware training using the clients’ equipment. The company offers beginning throughadvanced training with convenient scheduling. A small fleet of trucks transportspersonnel and teaching supplies to the clients’ sites. The company rents a buildingand is responsible for paying the utilities.We illustrate the capital stock transaction that occurred to form the company(in November) and the first month of operations (December). The accounting processused by this company is similar to that of any small company. The ledger accounts usedby MicroTrain Company are:LiabilitiesStockholders’equity
6060PART II Processing Information for Decisions and Establishing Accounting PolicyNotice the gaps left between account numbers (100, 103, 107, etc.). Thesegaps allow the firm to later add new accounts between the existing accounts.To begin, a transaction must be journalized.Journalizing is the process of enteringthe effects of a transaction in a journal. Then, the information is transferred, or posted,to the proper accounts in the ledger. Postingis the process of recording in the ledgeraccounts the information contained in the journal. We explain posting in more detaillater in the chapter.In the following example, notice that each business transaction affects two ormore accounts in the ledger. Also note that the transaction date in both the generaljournal and the general ledger accounts is the same. In the ledger accounts, the dateused is the date that the transaction was recorded in the general journal, even if theentry is not posted until several days later. Our example shows the journal entriesposted to T-accounts. In practice, firms post journal entries to ledger accounts, as weshow later in the chapter.Accountants use the accrual basis of accounting.Under theaccrual basis ofaccounting, they recognize revenues when the company makes a sale or performs aservice, regardless of when the company receives the cash. They recognize expensesas incurred, whether or not the company has paid out cash. Chapter 3 discusses theaccrual basis of accounting in more detail.In the following MicroTrain Company example, transaction 1 increases (debits)Cash and increases (credits) Capital Stock by $50,000. First, MicroTrain records thetransaction in the general journal; second, it posts the entry to the accounts in thegeneral ledger.No other transactions occurred in November. The company prepares financialstatements at the end of each month. Illustration 2.5 shows the company’s balancesheet at November 30, .The balance sheet reflects ledger account balances as of the close of businesson November 30, 2007. These closing balances are the beginning balances onDecember 1, 2007. The ledger accounts show these closing balances as beginningbalances (Beg. bal.).Now assume that in December 2007, MicroTrain Company engaged in thefollowing transactions. We show the proper recording of each transaction in the journaland then in the ledger accounts (in T-account form), and describe the effects of eachtransaction.The Recording ofTransactions andTheir Effects on theAccountsGeneral JournalDateAccount Titles and ExplanationPost.Ref.DebitCredit2007Nov.28 Cash1005 0 0 0 0Capital Stock3005 0 0 0 0Stockholders invested $50,000 cash in business.(Dr.)CashAcct. No. 100(Cr.)2007Nov. 2850,000(Dr.)Capital StockAcct. No. 300(Cr.)2007Nov. 2850,000General LedgerTransaction 1: Nov. 28, 2007 Stockholders invested $50,000 and formed MicroTrain Company.
61CHAPTER 2 Recording Business TransactionsTransaction 2: Dec. 1 Paid cash for four small trucks, $40,000.Transaction 2: Transaction 3: Dec. 1 Paid cash for insurance on the trucks to cover a one-year period from this date.Transaction 3: Paid cash for insurance on the trucks to cover a one-year period from this date.MICROTRAIN COMPANYBalance SheetNovember 30, 2007AssetsLiabilities and Stockholders’ EquityCash$50,000Stockholders’ equity:Capital stock$50,000Total Assets$50,000Total liabilities and stockholders’equity$50,000Illustration 2.5 Balance SheetGeneral JournalDateAccount Titles and ExplanationPost.Ref.DebitCredit2007Dec.1Prepaid Insurance1082 4 0 0Cash1002 4 0 0Purchased truck insurance to cover a one-year period.General Ledger(Dr.)Prepaid InsuranceAcct. No. 108(Cr.)2007Dec. 12,400(Dr.)CashAcct. No. 100(Cr.)2007Dec. 1 Beg. Bal.50,0002007Dec. 140,000Dec. 12,400Effects of TransactionAn asset, prepaid insurance, increases (debited); and an asset,cash, decreases (credited) by $2,400. The debit is to PrepaidInsurance rather than Insurance Expense because the policy coversmore than the current accounting period of December (insurancepolicies are usually paid one year in advance). As you will see inChapter 3, prepaid items are expensed as they are used. If thisinsurance policy was only written for December, the entire $2,400debit would have been to Insurance Expense.General JournalDateAccount Titles and ExplanationPost.Ref.DebitCredit2007Dec.1Trucks1504 0 0 0 0Cash1004 0 0 0 0To record the purchase of four trucks.General Ledger(Dr.)TrucksAcct. No. 150(Cr.)2007Dec. 140,000(Dr.)CashAcct. No. 100(Cr.)2007Dec. 1 Beg. bal.50,0002007Dec. 140,000Reinforcing ProblemE2–4 Prepare journalentries.
6262PART II Processing Information for Decisions and Establishing Accounting PolicyTransaction 4: Dec. 1 Rented a building and paid $1,200 to cover a three-month period from this date.Transaction 4: Dec. 1 Rented a building and paid $1,200 to cover a three-month period from this date.Transaction 5: Dec. 4 Purchased $1,400 of training supplies on account to be used over the next severalPurchased $1,400 of training supplies on account to be used over the next severalmonths.Reinforcing ProblemE2–5 Show entries usingjournal entries and T-accounts.General JournalDateAccount Titles and ExplanationPost.Ref.DebitCredit2007Dec.4Supplies on Hand1071 4 0 0Accounts Payable2001 4 0 0To record the purchases of training supplies for future use.General Ledger(Dr.)Supplies on HandAcct. No. 107(Cr.)2007Dec. 41,400(Dr.)Accounts PayableAcct. No. 200(Cr.)2007Dec. 41,400Effects of TransactionAn asset, supplies on hand, increases (debited); and a liability,accounts payable, increases (credited) by $1,400. The debit is toSupplies on Hand rather than Supplies Expense because the suppliesare to be used over several accounting periods.Effects of TransactionEffects of TransactionAn asset, prepaid rent, increases (debited); and another asset,cash, decreases (credited) by $1,200. The debit is to Prepaid Rentrather than Rent Expense because the payment covers more thanthe current month. If the payment had just been for December,the debit would have been to Rent Expense.General JournalDateAccount Titles and ExplanationPost.Ref.DebitCredit2007Dec.1Prepaid Rent1121 2 0 0Cash1001 2 0 0Paid three months’ rent on a building.General Ledger(Dr.)Prepaid RentAcct. No. 112(Cr.)2007Dec. 11,200(Dr.)CashAcct. No. 100(Cr.)2007Dec. 1 Beg. Bal.50,0002007Dec. 140,000Dec. 12,400Dec. 11,200In each of the three preceding entries, we debited an asset rather than an expense.The reason is that the expenditure applies to (or benefits) more than just the currentaccounting period. Whenever a company will not fully use up an item such as insurance,rent, or supplies in the period when purchased, it usually debits an asset. In practice,however, sometimes the expense is initially debited in these situations.Companies sometimes buy items that they fully use up within the currentaccounting period. For example, during the first part of the month a company may buysupplies that it intends to consume fully during that month. If the company fully consumes