In Chapter 1 we illustrated the income statement statement of retained earnings

In chapter 1 we illustrated the income statement

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In Chapter 1, we illustrated the income statement, statement of retained earnings, balance sheet, and statement of cash flows. These statements are the end products of the financial accounting process, which is based on the accounting equation. The financial accounting process quantifies past management decisions. The results of these decisions are communicated to users—management, creditors, and investors—and serve as a basis for making future decisions. The raw data of accounting are the business transactions. We recorded the transactions in Chapter 1 as increases or decreases in the assets, liabilities, and stockholders’ equity items of the accounting equation. This procedure showed you how various transactions affected the accounting equation. When working through these sample transactions, you probably suspected that listing all transactions as increases or decreases in the transactions summary columns would be too cumbersome in practice. Most businesses, even small ones, enter into many transactions every day. Chapter 2 teaches you how to actually record business transactions in the accounting process. To explain the dual procedure of recording business transactions with debits and 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 recorded debits and credits. This is the double-entry accounting system that the Franciscan monk, Luca Pacioli, described centuries ago. Understanding this system enables you to better understand the content of financial statements so you can use the information provided to make informed business decisions. The Account and Rules of Debit and Credit A business may engage in thousands of transactions during a year. An accountant classifies and summarizes the data in these transactions to create useful information. 1. 1. Use the account as the basic classifying and storage unit for accounting information. 2. 2. 2. 2. Express the effects of business transactions in terms of debits and credits to different types of accounts. 3.3.3.3.List the steps in theaccounting cycle. 4. 4. 4. 4. Record the effects of business transactions in a journal. 5. 5. Post journal entries to the accounts in the ledger. ( continued )
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50 50 PART II Processing Information for Decisions and Establishing Accounting Policy An Accounting An Accounting Perspective Perspective Steps in Recording Business Transactions Look at Illustration 2.1 to see the steps in recording and posting the effects of a business transaction. Note that source documents provide the evidence that a business transaction occurred. These source documents include such items as bills received from suppliers for goods or services received, bills sent to customers for goods sold or services performed, and cash register tapes. The information in the source document serves as the basis for preparing a journal entry. Then a firm posts (transfers) that information to accounts in the ledger. You can see from Illustration 2.1 that after you prepare the journal entry, you post 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 begin by studying the nature of an account. Fortunately, most business transactions are repetitive. This makes the task of accountants somewhat easier because they can classify the transactions into groups having common characteristics. For example, a company may have thousands of receipts or payments of cash during a year. As a result, a part of every cash transaction can be recorded and summarized in a single place called an account. An account is a part of the accounting system used to classify and summarize the increases, decreases, and balances of each asset, liability, stockholders’ equity item, dividend, revenue, and expense. Firms set up accounts for each different business element, such as cash, accounts receivable, and accounts payable. Every business has a Cash account in its accounting system because knowledge of the amount of cash on hand is useful information. Accountants may differ on the account title (or name) they give the same item. For example, one accountant might name an account Notes Payable and another might call it Loans Payable. Both account titles refer to the amounts borrowed by the company. The account title should be logical to help the accountant group similar transactions into the same account. Once you give an account a title, you must use that same title throughout the accounting records. The number of accounts in a company’s accounting system depends on the information needs of those interested in the business. The main requirement is that each account provides information useful in making decisions. Thus, one account may be 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 is useful 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, appears across the top of the T. We record increases on one side of the vertical line of the T and decreases on the other side. A T-account appears as follows: Title of Account Business Insight Business Insight Have you ever considered starting your own business? If so, you’ll need to understand accounting to successfully run your business. To know how well your business is doing, you must understand and analyze financial statements. Accounting information also tells you why you are performing as reported. If you are in business to sell or develop a certain product or perform a specific service, you cannot operate profitably or consider expanding unless you base your business decisions on accounting information. Note to the Student Give an example of a business you would like to start or in which you are presently working. Develop typical transactions of the business and analyze these transactions. The T-Account Objectives 6. Prepare a trial balance to test the equality of debits and credits in the journalizing and posting process. 7. Analyze and use the financial results— horizontal and vertical analyses. Objective 1 Use the account as the basic classifying and storage unit for accounting information. The Account
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51 CHAPTER 2 Recording Business Transactions In Chapter 1, you saw that each business transaction affects at least two items. For example, if you—an owner—invest cash in your business, the company’s assets increase and its stockholders’ equity increases. This result was illustrated in the summary of transactions in Illustration 1.3. In the following sections, we use debits and credits and the double-entry procedure to record the increases and decreases caused by business transactions. Accountants use the term debit instead of saying, “Place an entry on the left side of the T-account.” They use the term credit for “Place an entry on the right side of the T- account.” Debit (abbreviated Dr.) simply means left side; credit (abbreviated Cr.) means right side. 1 Thus, for all accounts a debit entry is an entry on the left side, while a credit entry is an entry on the right side. Any Account Left, or Right, or debit, side credit, side After recognizing a business event as a business transaction, we analyze it to determine its increase or decrease effects on the assets, liabilities, stockholders’ equity items, dividends, revenues, or expenses of the business. Then we translate these increase or decrease effects into debits and credits. In each business transaction we record, the total dollar amount of debits must equal 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 accounting requirement that each transaction be recorded by an entry that has equal debits and credits is called double-entry procedure , or duality. This double-entry procedure keeps the accounting equation in balance. The dual recording process produces two sets of accounts—those with debit balances and those with credit balances. The totals of these two groups of accounts must be equal. Then, some assurance exists that the arithmetic part of the transaction recording process has been properly carried out. Now, let us actually record business transactions in T-accounts using debits and credits. Recording Changes in Assets, Liabilities, and Stockholders’ Equity While recording business transactions, remember that the foundation of the accounting process is the following basic accounting equation: Assets = Liabilities + Stockholders’ Equity Recording transactions into the T-accounts is easier when you focus on the equal sign in the accounting equation. Assets, which are on the left of the equal sign, Debits and Credits Note to the Student Debit and credit are directional signals. The limited meaning of debit is to record the amount on the left side of the account; the limited meaning of credit is to record the amount on the right side of the account. Illustration 2.1 The Steps in Recording and Posting the Effects of a Business Transaction Double-Entry Procedure Objective 2 Express the effects of business transactions in terms of debits and credits to different types of accounts. The company enters into business transaction as the result of a management decision The company transaction is evidenced by a source document The source document serves as the basis for preparing a journal entry The journal entry is posted to the accounts in the ledger 1 The abbreviations “Dr.” and “Cr.” are based on the Latin words “ d ebe r e” and “ c rede r e.” A synonym for debit an account is charge an account.
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52 52 PART II Processing Information for Decisions and Establishing Accounting Policy increase on the left side of the T-accounts. Liabilities and stockholders’ equity, to the right of the equal sign, increase on the right side of the T-accounts. You already know that 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 by deduction, such as: Assets = Liabilities + Stockholders’ Equity Debit for increases Credit for decreases Debit for decreases Credit for increases Debit for decreases Credit for increases To 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-account and increase by credits (right side) to the T-account. Applying these two rules keeps the accounting equation in balance. Now we apply the debit and credit rules for assets, liabilities, and stockholders’ equity to business transactions. 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 two sides of the transaction together.) The company records the receipt of $10,000 as follows: (Dr.) Cash (Cr.) (Dr.) Capital Stock (Cr (1) 10,000 (1) 10,00 This transaction increases the asset, cash, which is recorded on the left side of the Cash account. Then, the transaction increases stockholders’ equity, which is recorded on the right side of the Capital Stock account. Assume the company borrowed $5,000 from a bank on a note (transaction 2). A note is an unconditional written promise to pay to another party (the bank) the amount owed either when demanded or at a specified date, usually with interest at a specified rate. The firm records this transaction as follows: (Dr.) Cash (Cr.) (Dr.) Notes Payable (Cr.) (1) 10,000 (2) 5,000 (2) 5,000 Observe that liabilities, Notes Payable, increase with an entry on the right (credit) side of the account. Recording Changes in Revenues and Expenses In Chapter 1, we recorded the revenues and expenses directly in the Retained Earnings account. However, this is not done in practice because of the volume of revenue and expense transactions. Instead, businesses treat the expense accounts as if they were subclassifications of the debit side of the Retained Earnings account, and the revenue accounts as if they were subclassifications of the credit side. Since firms need the amounts of revenues and expenses to prepare the income statement, they keep a separate account for each type of revenue and expense. The recording rules for revenues and expenses are: Reinforcing Problem Reinforcing Problem E2–1 Indicate rules of debit and credit. Real World Example Aetna Inc., the largest U.S. health insurer, announced on December 13, 2001 that it planned to cut about 6,000 jobs, eliminating nearly a sixth of its work force. How would this event impact the financial statements? Reinforcing Problem E2–6 Explain sets of debits and credits.
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53 CHAPTER 2 Recording Business Transactions · Record increases in revenues on the right (credit) side of the T-account and decreases on the left (debit) side. The reasoning behind this rule is that revenues increase retained earnings, and increases in retained earnings are recorded on the right side. · Record increases in expenses on the left (debit) side of the T-account and decreases on the right (credit) side. The reasoning behind this rule is that expenses decrease retained earnings, and decreases in retained earnings are recorded on the left side. To illustrate these rules, assume the same company received $1,000 cash from 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; and the Salaries Expense account, a decrease in retained earnings, increases on the left (debit) side. 2 Recording Changes in Dividends Since dividends decrease retained earnings, increases appear on the left side of the Dividends account and decreases on the right side. Thus, the firm records payment of a $2,000 cash dividend (transaction 5) as follows: At the end of the accounting period, the accountant transfers any balances in the expense, revenue, and Dividends accounts to the Retained Earnings account. This transfer occurs only after the information in the expense and revenue accounts has been used to prepare the income statement. We discuss and illustrate this step in Chapter 4. To determine the balance of any T-account, total the debits to the account, total the credits to the account, and subtract the smaller sum from the larger. If the sum of the debits exceeds the sum of the credits, the account has a debit balance . For example, the following Cash account uses information from the preceding transactions. The account has a debit balance of $13,400, computed as total debits of $16,000 less total credits of $2,600. (Dr.) Cash (Cr.) (Dr.) Dividends 3 (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) 1,000 Determining the Balance of an Account 2 Certain deductions are normally taken out of employees’ pay for social security taxes, federal and state withholding, and so on. Those deductions are ignored here. 3 As we illustrate later in the text, some companies debit dividends directly to the Retained Earnings account rather than to a Dividends account.
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54 54 PART II Processing Information for Decisions and Establishing Accounting Policy (Dr.) Cash (Cr.) (1) 10,000 (4) 600 (2) 5,000 (5) 2,000 (3) 1,000 16,000 2,600 Dr. bal 13,400 If, on the other hand, the sum of the credits exceeds the sum of the debits, the account has a credit balance . For instance, assume that a company has an Accounts Payable account with a total of $10,000 in debits and $13,000 in credits. The account has a credit balance of $3,000, as shown in the following T-account: (Dr.) Accounts Payable (Cr.) 10,000 7,000 6,000 10,000 13,000 Cr. bal 3,000 Normal Balances Since debits increase asset, expense, and Dividend accounts, they normally have debit (or left-side) balances. Conversely, because credits increase liability, capital stock, retained earnings, and revenue accounts, they normally have credit (or right-side) balances. The following chart shows the normal balances of the seven accounts we have used: Normal Balances Types of Accounts Debit Credit Assets X Liabilities X Stockholders’ Equity Capital Stock X Retained earnings X Dividends X Expenses X Revenues X At this point, you should memorize the six rules of debit and credit. Later, as you proceed in your study of accounting, the rules will become automatic. Then, you will no 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’ Equity Debits = Credits The arrangement of these two formulas gives the first three rules of debit and credit: 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 and Credit Summarized
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55 CHAPTER 2 Recording Business Transactions Asset Accounts = Liability Accounts + Stockholders’ Equity Account(s) (Capital Stock and Retained Earnings) Debit* Credit Debit Credit* Debit Credit* + Debit for increase Credit for decrease Debit for decrease + Credit for increase Debit for decrease + Credit for increase Debits Credits Expense Accounts and Dividends Account Revenue Accounts 1. Increase assets. 1. Decreases assets. Debit* Credit Debit Credit* 2. Decrease liabilities. 2. Increase liabilities. 3. Decrease stockholders’ equity. 3. Increase stockholders’ equity. 4. Decrease revenues. 4. Increase revenues. 5. Increase expenses. 5. Decrease expenses. 6. Increase dividends. 6. Decrease dividends. + Debit for increase Credit for decrease Debit for decrease + Credit for increase * Normal balance Objective 3 List the steps in the accounting cycle. Illustration 2.2 Rules of Debit and Credit The debit and credit rules for expense and Dividends accounts and for revenue accounts follow logically if you remember that expenses and dividends are decreases in stockholders’ equity and revenues are increases in stockholders’ equity. Since stockholders’ equity accounts decrease on the debit side, expense and Dividend accounts increase on the debit side. Since stockholders’ equity accounts increase on the credit side, revenue accounts 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 the treatment of expense and Dividends accounts as if they were subclassifications of the debit side of the Retained Earnings account. Second, note the treatment of the revenue accounts as if they were subclassifications of the credit side of the Retained Earnings account. Next, we discuss the accounting cycle and indicate where steps in the accounting cycle are discussed in Chapters 2 through 4. The Accounting Cycle The 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 to recognize a business transaction. Business transactions are measurable events that affect the financial condition of a business. For example, assume that the owner of a business spilled a pot of coffee in her office or broke her leg while skiing. These two events may briefly interrupt the operation of the business. However, they are not measurable in terms that affect the solvency and profitability of the business. Business transactions can be the exchange of goods for cash between the business and an external party, such as the sale of a book, or they can involve paying Assets Liabilities Stockholder’s Equity = +
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56 56 PART II Processing Information for Decisions and Establishing Accounting Policy salaries to employees. These events have one fundamental criterion: They must have caused a measurable change in the amounts in the accounting equation, Assets = Liabilities + Stockholders’ Equity. The evidence that a business event has occurred is a source document such as a sales ticket, check, and so on. Source documents are important because they are the ultimate proof of business transactions. 4 After you have determined that an event is a measurable business transaction and have adequate proof of this transaction, mentally analyze the transaction’s effects on the accounting equation. You learned how to do this in Chapter 1. This chapter and Chapters 3 and 4 describe the other steps in the accounting cycle. The eight steps in the 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. Step 5 precedes steps 6 and 7 because management needs the financial statements at the earliest possible date. After the statements have been delivered to management, the adjusting and closing entries can be journalized and posted. In Illustration 2.3, we diagram the eight steps in the accounting cycle. You can perform many of these steps on a computer with an accounting software package. However, you must understand a manual accounting system and all of the steps in the accounting cycle to understand what the computer is doing. This understanding removes the mystery of what the computer is doing when it takes in raw data and produces financial statements. The Journal In 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 show how the cash was generated or how it was spent. To have a permanent record of an entire transaction, the accountant uses a book or record known as a journal. A journal is a chronological (arranged in order of time) record of business transactions. A journal entry is the recording of a business transaction in the journal. A journal entry shows all the effects of a business transaction as expressed in debit(s) and credit(s) and may include an explanation of the transaction. A transaction is entered in a journal before it is entered in ledger accounts. Because each transaction is initially recorded in 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 several special 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 of the accounting period. Performed throughout the accounting period Objective 4 Record the effects of business transactions in a journal. The General Journal 4 Many companies send and receive source documents electronically, rather than on paper. In such an electronic computer environment, source documents might exist only in the computer databases of the two parties involved in the transaction.
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57 CHAPTER 2 Recording Business Transactions Illustration 2.3 Steps in the Accounting Cycle 1. Date column. The first column on each journal page is for the date. For the first journal 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 the month, until the month changes. 2. Account Titles and Explanation column. The first line of an entry shows the account debited. The second line shows the account credited. Notice that we indent the credit account title to the right. For instance, in Illustration 2.4 we show the debit to the Cash account and then the credit to the Capital Stock account. Any necessary explanation of a transaction appears on the line(s) below the credit entry and is indented halfway between the accounts debited and credited. A journal entry explanation should be concise and yet complete enough Illustration 2.4 General Journal MICROTRAIN COMPANY General Journal Date Account Titles and Explanation Post. Ref. Debit Credit 2007 Nov. 28 Cash 100 5 0 0 0 0 Capital Stock 300 5 0 0 0 0 Stockholders invested $50,000 cash in business. Reinforcing Problems Reinforcing Problems E2–2 Prepare journal entries E2–3 Prepare journal entries
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58 58 PART II Processing Information for Decisions and Establishing Accounting Policy An Accounting An Accounting An Accounting An Accounting to describe fully the transaction and prove the entry’s accuracy. When a journal entry is self-explanatory, we omit the explanation. 3. Posting Reference column. This column shows the account number of the debited or credited account. For instance, in Illustration 2.4, the number 100 in the first entry means that the Cash account number is 100. No number appears in this column until the information has been posted to the appropriate ledger account. We discuss posting later in the chapter. 4. Debit column. In the debit column, the amount of the debit is on the same line as the title of the account debited. 5. Credit column. In the credit column, the amount of the credit is on the same line as the title of the account credited. Uses of Technology Uses of Technology Preparing journal entries in a computerized system is different than in a manual system. The computer normally asks for the number of the account to be debited. After you type the account number, the computer shows the account title in its proper position. The cursor then moves to the debit column and waits for you to enter the amount of the debit. Then it asks if there are more debits. If not, the computer prompts you for the account number of the credit. After you type the account number, the computer supplies the account name of the credit and enters the same amount debited as the credit. When there is more than one credit, you can override the amount and enter the correct amount. Then you would enter the other credit in the same way. If your debits and credits are not equal, the computer warns you and makes you correct the error. You can supply an explanation for the entry from a standard list or type it in. As you enter the journal entries, the computer automatically posts them to the ledger accounts. At any time, 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 equal the credit(s) in each journal entry. 8. Aids in tracing errors when the ledger is not in balance. The Ledger A 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 and expenses). The terms real accounts and permanent accounts also refer to balance sheet accounts. Balance sheet accounts are real accounts because they are not subclassifications or subdivisions of any other account. They are permanent accounts because their balances are not transferred (or closed) to any other account at the end of the accounting period. Income statement accounts and the Dividends account are nominal accounts because they are merely subclassifications of the stockholders’ equity accounts. Nominal literally means “in name only.” Nominal accounts are also called temporary accounts because they temporarily contain revenue, expense, and Reinforcing Problem P2–1A Prepare journal entries. Functions and Advantages of a Journal
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59 CHAPTER 2 Recording Business Transactions Acct. Account Title Description No. 100 Cash Bank deposits and cash on hand. 103 Accounts Receivable Amounts owed to the company by customers. 107 Supplies on Hand Items such as paper, envelopes, writing materials, and other materials used in performing training services for customers or in doing administrative Assets and clerical office work. 108 Prepaid Insurance Insurance policy premiums paid in advance of the periods for which the insurance coverage applies. 112 Prepaid Rent Rent paid in advance of the periods for which the rent payment applies. 150 Trucks Trucks used to transport personnel and training supplies to clients’ locations. 200 Accounts Payable Amounts owed to creditors for items purchased from them. 216 Unearned Service Fees Amounts received from customers before the training services have been performed for them. Stockholders’ 300 Capital Stock The stockholders’ investment in the business. equity 310 Retained Earnings The earnings retained in the business. Dividends 320 Dividends The amount of dividends declared to stockholders. Revenues 400 Service Revenue Amounts earned by performing training services for customers. 505 Advertising Expense The cost of advertising incurred in the current period. 506 Gas and Oil Expense The cost of gas and oil used in trucks in the Expenses current period. 507 Salaries Expense The amount of salaries incurred in the current period. 511 Utilities Expense The cost of utilities incurred in the current period. dividend information that is transferred (or closed) to the Retained Earnings account at the end of the accounting period. The chart of accounts is a complete listing of the titles and numbers of all the 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 has an 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; revenue accounts, 400–499; and expense accounts, 500–599. We use this numbering system in this text. The uniform chart of accounts used in the first 11 chapters appears in a separate file at the end of the text. You should print that file and keep it handy for working certain problems and exercises. Companies may use other numbering systems. For instance, sometimes a company numbers its accounts in sequence starting with 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 how all accounts together form a ledger, you are ready to study the accounting process in operation. The Accounting Process in Operation MicroTrain Company is a small corporation that provides on-site microcomputer software training using the clients’ equipment. The company offers beginning through advanced training with convenient scheduling. A small fleet of trucks transports personnel and teaching supplies to the clients’ sites. The company rents a building and 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 process used by this company is similar to that of any small company. The ledger accounts used by MicroTrain Company are: Liabilities Stockholders’ equity
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60 60 PART II Processing Information for Decisions and Establishing Accounting Policy Notice the gaps left between account numbers (100, 103, 107, etc.). These gaps allow the firm to later add new accounts between the existing accounts. To begin, a transaction must be journalized. Journalizing is the process of entering the effects of a transaction in a journal. Then, the information is transferred, or posted, to the proper accounts in the ledger. Posting is the process of recording in the ledger accounts the information contained in the journal. We explain posting in more detail later in the chapter. In the following example, notice that each business transaction affects two or more accounts in the ledger. Also note that the transaction date in both the general journal and the general ledger accounts is the same. In the ledger accounts, the date used is the date that the transaction was recorded in the general journal, even if the entry is not posted until several days later. Our example shows the journal entries posted to T-accounts. In practice, firms post journal entries to ledger accounts, as we show later in the chapter. Accountants use the accrual basis of accounting. Under the accrual basis of accounting , they recognize revenues when the company makes a sale or performs a service, regardless of when the company receives the cash. They recognize expenses as incurred, whether or not the company has paid out cash. Chapter 3 discusses the accrual 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 the transaction in the general journal; second, it posts the entry to the accounts in the general ledger. No other transactions occurred in November. The company prepares financial statements at the end of each month. Illustration 2.5 shows the company’s balance sheet at November 30, . The balance sheet reflects ledger account balances as of the close of business on November 30, 2007. These closing balances are the beginning balances on December 1, 2007. The ledger accounts show these closing balances as beginning balances (Beg. bal.). Now assume that in December 2007, MicroTrain Company engaged in the following transactions. We show the proper recording of each transaction in the journal and then in the ledger accounts (in T-account form), and describe the effects of each transaction. The Recording of Transactions and Their Effects on the Accounts General Journal Date Account Titles and Explanation Post. Ref. Debit Credit 2007 Nov. 28 Cash 100 5 0 0 0 0 Capital Stock 300 5 0 0 0 0 Stockholders invested $50,000 cash in business. (Dr.) Cash Acct. No. 100 (Cr.) 2007 Nov. 28 50,000 (Dr.) Capital Stock Acct. No. 300 (Cr.) 2007 Nov. 28 50,000 General Ledger Transaction 1: Nov. 28, 2007 Stockholders invested $50,000 and formed MicroTrain Company.
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61 CHAPTER 2 Recording Business Transactions Transaction 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 COMPANY Balance Sheet November 30, 2007 Assets Liabilities and Stockholders’ Equity Cash $50,000 Stockholders’ equity: Capital stock $50,000 Total Assets $50,000 Total liabilities and stockholders’ equity $50,000 Illustration 2.5 Balance Sheet General Journal Date Account Titles and Explanation Post. Ref. Debit Credit 2007 Dec. 1 Prepaid Insurance 108 2 4 0 0 Cash 100 2 4 0 0 Purchased truck insurance to cover a one-year period. General Ledger (Dr.) Prepaid Insurance Acct. No. 108 (Cr.) 2007 Dec. 1 2,400 (Dr.) Cash Acct. No. 100 (Cr.) 2007 Dec. 1 Beg. Bal. 50,000 2007 Dec. 1 40,000 Dec. 1 2,400 Effects of Transaction An asset, prepaid insurance, increases (debited); and an asset, cash, decreases (credited) by $2,400. The debit is to Prepaid Insurance rather than Insurance Expense because the policy covers more than the current accounting period of December (insurance policies are usually paid one year in advance). As you will see in Chapter 3, prepaid items are expensed as they are used. If this insurance policy was only written for December, the entire $2,400 debit would have been to Insurance Expense. General Journal Date Account Titles and Explanation Post. Ref. Debit Credit 2007 Dec. 1 Trucks 150 4 0 0 0 0 Cash 100 4 0 0 0 0 To record the purchase of four trucks. General Ledger (Dr.) Trucks Acct. No. 150 (Cr.) 2007 Dec. 1 40,000 (Dr.) Cash Acct. No. 100 (Cr.) 2007 Dec. 1 Beg. bal. 50,000 2007 Dec. 1 40,000 Reinforcing Problem E2–4 Prepare journal entries.
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62 62 PART II Processing Information for Decisions and Establishing Accounting Policy Transaction 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 several Purchased $1,400 of training supplies on account to be used over the next several months. Reinforcing Problem E2–5 Show entries using journal entries and T- accounts. General Journal Date Account Titles and Explanation Post. Ref. Debit Credit 2007 Dec. 4 Supplies on Hand 107 1 4 0 0 Accounts Payable 200 1 4 0 0 To record the purchases of training supplies for future use. General Ledger (Dr.) Supplies on Hand Acct. No. 107 (Cr.) 2007 Dec. 4 1,400 (Dr.) Accounts Payable Acct. No. 200 (Cr.) 2007 Dec. 4 1,400 Effects of Transaction An asset, supplies on hand, increases (debited); and a liability, accounts payable, increases (credited) by $1,400. The debit is to Supplies on Hand rather than Supplies Expense because the supplies are to be used over several accounting periods. Effects of Transaction Effects of Transaction An asset, prepaid rent, increases (debited); and another asset, cash, decreases (credited) by $1,200. The debit is to Prepaid Rent rather than Rent Expense because the payment covers more than the current month. If the payment had just been for December, the debit would have been to Rent Expense. General Journal Date Account Titles and Explanation Post. Ref. Debit Credit 2007 Dec. 1 Prepaid Rent 112 1 2 0 0 Cash 100 1 2 0 0 Paid three months’ rent on a building. General Ledger (Dr.) Prepaid Rent Acct. No. 112 (Cr.) 2007 Dec. 1 1,200 (Dr.) Cash Acct. No. 100 (Cr.) 2007 Dec. 1 Beg. Bal. 50,000 2007 Dec. 1 40,000 Dec. 1 2,400 Dec. 1 1,200 In 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 current accounting 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 current accounting period. For example, during the first part of the month a company may buy supplies that it intends to consume fully during that month. If the company fully consumes
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