What does the term account mean? What are the different classifications of accounts? How do the rules for debits and credits impact accounts? Please provide an example of how debits and credits impact accounts. chapter 2 The Accounting System Copyright Barbara Chase/Corbis/AP Images Learning Goals waL80144_02_c02_027-052.indd 1 • Understand the need for and general characteristics of a proper accounting system. • Understand accounts and how they are impacted by the debit/credit rules. • Know how to prepare journal entries to describe the effects of transactions and events. • Post accounts to the general ledger and prepare a trial balance. • Apply features and tools that are used to enhance and improve accounting systems and processes. 8/29/12 2:43 PM CHAPTER 2 Section 2.1 System Design Chapter Outline 2.1 System Design 2.2 Accounts and Debits/Credits Debit and Credit Rules T-Accounts 2.3 Transaction Analysis Critical Thinking About Transaction Analysis An Applied Example of Transaction Analysis 2.4 General Journal 2.5 Chart of Accounts Posting the General Ledger Trial Balance Review of the Sequence of Transaction Recording A Balanced Trial Balance: No Guarantee of Correctness Special Journals 2.6 Source Documents 2.7 Thinking About Automation 2.8 Critical Thinking About Debits and Credits E xhibit 1.5 shows how transactions systematically impact the accounting equation and resulting financial statements. Although this system works fine as an introduction to the accounting equation, it is not adequate for managing an actual business. Too many transactions originate in too many places for a single tabulation to capture all business activity reliably. Many small businesses have tried to use a simple schedule or spreadsheet to record and process all their activities; however, chaos quickly rules. A more complete and controlled accounting system is needed. 2.1 System Design L arge and successful businesses have invariably developed robust accounting information systems. This suggests that the pathway to business success entails more than just product development and marketing. It also entails thoughtful development of welldesigned accounting information systems. It is far better to establish a proper system at the outset of launching a business, rather than coming back later and trying to repair an inadequate system. By the time a business discovers that its system is deficient, it is often too late. The business may well have lost control of necessary information for proper business management. The results are often disastrous. This naturally leads you to wonder about the core elements of a proper system. Clearly, the accounting system must provide a basis for preparing financial statements. This is the 28 waL80144_02_c02_027-052.indd 2 8/29/12 2:43 PM CHAPTER 2 Section 2.2 Accounts and Debits/Credits end objective and reflects the aggregation of all activity. Thus, the goal of an accounting system is to process transactions and events reliably into useful financial statements and reports. However, the system must also maintain retrievable documentation for every transaction. An important feature is to allow a user to query the system for the purpose of retrieving, verifying, or examining individual details of any specific business transaction. Computerized accounting systems summarize and interpret all business transactions. The result is useful financial data for purposes of investment and business management. Much of the data input can actually originate with the transaction’s execution. For instance, while recording a customer’s purchase at a point-of-sale terminal, accounting records can be updated to reflect the sale. This can additionally trigger adjustments of the company’s inventory records and even generate an order to a vendor to replace depleted stock on hand. While this level of sophistication can simplify the data entry process and increase accuracy of subsequent processing, it also entails considerable risk of “invisible” manipulation of data and file destruction. Thus, a good accounting system must take into consideration the need to control access, verify input, and back up essential records. Even with these important controls, a welltrained accountant must be knowledgeable and vigilant. A basic understanding of debits/ credits, journals, and other basic topics is essential to interpret computerized reports and spot errors that may have been inadvertently (or worse, deliberately) introduced into the system. Computerized accounting information systems are typically built around a database structure. This means that data are stored in an electronic array, including a variety of descriptive codes and indices. This coding process allows you to query the database to extract desired information instantaneously, based on parameters established by the person initiating the request of the accounting system. The long-standing structure of the core financial statements and the basic tools used in their construction are generally preserved in even the most sophisticated electronic environments. Indeed, it is difficult to understand or work within an automated accounting environment without first being moderately familiar and comfortable with the basic accounting tools. This chapter introduces these important tools and helps you understand how they can be effectively used to capture and process information. 2.2 Accounts and Debits/Credits A n account is the master record that is maintained for each individual financial statement asset, liability, equity, revenue, expense, or dividend component. Every financial statement element (cash, accounts receivable, inventory, land, accounts payable, etc.) would have its own account and show the impact of all transactions causing a change to that account. The collection of all accounts is known as the general ledger. Importantly, the collective balance of all accounts should conform to the accounting equation, meaning that the sum of all asset accounts will equal the sum of all liability and equity components. Of course, in considering this equation, you need to be mindful that the revenue account increases equity and expenses and dividends decrease equity. 29 waL80144_02_c02_027-052.indd 3 8/29/12 2:43 PM CHAPTER 2 Section 2.2 Accounts and Debits/Credits Beginning students are typically mystified about how this equality is consistently preserved. There is an answer to this, and the answer’s brilliance helps explain how the fundamental accounting model has persevered for over 500 years. Indeed, that the model continues to be programmed into today’s highly sophisticated computerized systems speaks volumes about the integrity of the model. The key ingredient is the concept of debits and credits. Debits and credits are often misunderstood. You may have had your account credited at the bank, you might use a debit card to make a purchase, and you might prepare a credit application! The terms debit and credit are tossed around rather casually in day-to-day activities. At this point, the best thing to do is clear your mind of any meaning that you might already associate with the terms and start anew. Debits and credits are accounting tools, and you should focus on this important point: Every business transaction can be described in terms of debit/credit impacts on specific accounts so that debits will always equal credits. That is an amazing concept! By preserving this equality at the transaction level, the overall equality of the fundamental accounting equation is also preserved. You are perhaps skeptical? Let’s look closer at this model. Debit and Credit Rules It is best to begin by memorizing certain “rules” about debits and credits. These rules are not necessarily intuitive, but at least they are not hard to learn. Think of learning them in the same way that you might memorize a few key words in a unfamiliar language, prior to taking a trip to a place where that is the only language spoken. Accountants and businesspeople routinely speak about transactional effects in the context of debits and credits. Debit (often abbreviated “dr” and sometimes taken to mean “to record on the left-hand side of an account,” as will become apparent shortly) is simply the action of recording an increase to an asset, expense, or dividend account. Conversely, credit (abbreviated “cr” and sometimes taken to mean “to record on the right-hand side of an account”) is the action of recording a decrease to those same accounts. For example, if Cash (an asset) is increased, we say that we are debiting cash. If Accounts Receivable (another asset) is decreased, we say that we are crediting Accounts Receivable. Therefore, if a transaction involves collecting $1,000 cash from a customer who owes us the money (i.e., we have a previously established account receivable on our balance sheet), then we simply say that we are debiting Cash and crediting Accounts Receivable for $1,000. By their nature, asset, expense, and dividend accounts usually have more debits than credits and are said to have a normal debit balance (Exhibit 2.1). 30 waL80144_02_c02_027-052.indd 4 8/29/12 2:43 PM CHAPTER 2 Section 2.2 Accounts and Debits/Credits Exhibit 2.1: Assets, expenses, and dividend accounts Increased With Debits Decreased With Credits Assets Expenses Dividends Normal Balance Is Debit Liability, revenue, and equity accounts behave in an opposite fashion. They are increased with credits and decreased with debits. By their nature, these accounts usually have more credits than debits and are said to have a normal credit balance (Exhibit 2.2). Table 2.1 lists many typical accounts, showing the application of the debit and credit rules. Exhibit 2.2: Liability, revenue, and equity accounts Decreased With Debits Increased With Credits Liabilities Revenues Equity Normal Balance Is Credit 31 waL80144_02_c02_027-052.indd 5 8/29/12 2:43 PM CHAPTER 2 Section 2.2 Accounts and Debits/Credits Table 2.1: Schedule of debit and credit rules for typical accounts Normal Balance Increased With Decreased With Debit Debit Credit Credit Credit Debit Credit Credit Debit Credit Credit Debit Debit Debit Credit Debit Debit Credit Typical Assets Cash Accounts Receivable Inventory Land Buildings Equipment Typical Liabilities Accounts Payable Salaries Payable Notes and Loans Payable Typical Equities Capital Stock Retained Earnings Typical Revenues Service Revenue Sales Typical Expenses Salaries and Wages Utilities Interest Rent Supplies Taxes Dividends Dividends In addition to the preceding rules, a few select accounts are known as contra accounts. You will be exposed to these accounts in future chapters related to accounts receivable, plant assets, and certain long-term indebtedness. A contra account is an offset to another account and has opposite debit and credit rules. For example, the wear and tear on a plant asset via the passage of time can result in a reduction in the asset’s reported cost. This impact is reflected as accumulated depreciation, which is netted against (i.e., reported as contra to) the plant asset. Thus, the accumulated depreciation is reported within the asset section but has opposite debit and credit rules (e.g., increased with a credit and vice versa). This concept will be covered in more sufficient depth later. 32 waL80144_02_c02_027-052.indd 6 8/29/12 2:43 PM CHAPTER 2 Section 2.3 Transaction Analysis T-Accounts No introduction to accounting would be complete without mentioning T-accounts. A T-account is not part of an accounting system; it is only a device that is used to demonstrate the impact of certain transactions and events. T-accounts are useful teaching tools and are also used by accountants also use them when chatting about accounting effects. You can think of T-accounts as accounting on a napkin. A T-account is shaped like a “T,” with debits on the left and credits on the right. Exhibit 2.3 illustrates T-accounts showing the effects of purchasing $50,000 of equipment for $10,000 cash and a $40,000 note payable. In this case, Equipment (an asset) is increased via the debit; Cash (an asset) is decreased via the credit the credit; and Note Payable (a liability) is increased with a credit. Exhibit 2.3: T-accounts The only limit to what can be illustrated within T-accounts is the size of the paper on which they are drawn. Exhibit 2.4 shows a T-account for Cash corresponding to all activity that impacted this particular account (transactions are assumed for the sake of this illustration until later in this text). Notice that the excess of debits over credits equals the ending cash balance. Later in this chapter, you will see a comprehensive example for Clearview Window Washers, and this particular T-account will correspond to the cash transactions described therein. Exhibit 2.4: Sample T-account for Cash 2.3 Transaction Analysis T he process of maintaining accountability over a business’s affairs begins with an analysis of each transaction. You must determine what accounts are impacted and how they are impacted (increased or decreased). These increase/decrease impacts are then translated into the accounting language of debits and credits. You may be wondering why it is not possible to just use increase and decrease to describe effects on accounts. Simply put, increases will not always equal decreases. 33 waL80144_02_c02_027-052.indd 7 8/29/12 2:43 PM CHAPTER 2 Section 2.3 Transaction Analysis For example, if one purchased inventory (an asset) with an account payable (a liability), both sides of the balance sheet increase. In other words, Cash increases on the asset side, and Accounts Payable increases on the liability side. When converted to debit/credit consequence, the same transaction is described as a debit to Cash (assets are increased with debits) and a credit to Accounts Payable (liabilities are increased with credits). Identifying a transaction where debits do not appropriately equal credits is impossible. Conversely, it is possible to identify a mishmash of transactions that display every conceivable combination of increases and decreases, some of which are offsetting and others that are not. Is it starting to make sense why accountants stick with debit and credit nomenclature? Critical Thinking About Transaction Analysis Perhaps one of the more frustrating parts of learning accounting is developing the skills necessary to evaluate transactions and describe the debit/credit impacts on all affected accounts. This is akin to learning a new language. For most people, practice and repetition is required. If you try to skip over this part of the learning process, you will find yourself increasingly frustrated with future chapters. Table 2.2 is not exhaustive but is intended to provide you with some added guidance and practice in transaction analysis. Table 2.2: Transaction analysis Example Transactions Critical Thinking Conclusion Provide services for cash. Cash, an asset, and Revenues are both increased. Debit Cash. Credit Revenues. Provide services on account. Accounts Receivable, an asset, and Revenues are both increased. Debit Accounts Receivable. Credit Revenues. Pay an expense with cash. Expenses are increased and Cash, an asset, is decreased. Debit Expense. Credit Cash. Incur an expense on account. Expenses and Accounts Payable, a liability, are both increased. Debit Expense. Credit Accounts Payable. Buy an asset for cash. The specific asset purchased is increased, and Cash, an asset, is decreased. Debit Asset. Credit Cash. Buy an asset with debt. The specific asset purchased and Loan Payable, a liability, are both increased. Debit Asset. Credit Loan Payable. Collect an account. Cash, an asset, is increased, and Accounts Receivable, an asset, is decreased. Debit Cash. Credit Accounts Receivable. Pay an account. Cash, an asset, and Accounts Payable, a liability, are both decreased. Debit Accounts Payable. Credit Cash. Borrow cash. Cash, an asset, and Loan Payable, a liability, are both increased. Debit Cash. Credit Loan Payable. Issue stock for cash. Cash, an asset, and Capital Stock, an equity account, are both increased. Debit Cash. Credit Capital Stock. Pay a dividend. Dividends are increased and Cash, an asset, is decreased. Debit Dividends. Credit Cash. 34 waL80144_02_c02_027-052.indd 8 8/29/12 2:43 PM CHAPTER 2 Section 2.3 Transaction Analysis An Applied Example of Transaction Analysis To reiterate these important concepts, let’s revisit the example from Chapter 1 (see Table 1.2). This time, however, the table is expanded to include an extra column showing the debit and credit impacts (Table 2.3). Spend some quality time thinking about each transaction and how the proposed debit and credit impacts tie in to the debit and credit rules. Table 2.3: Debit and credit impacts Description Amount Discussion of How Balance Is Maintained Debit 5 Credit Translation Provided windowwashing services for cash. $ 10,000 Cash (an asset) and Revenues both increase; revenues increase income which increases equity. Cash, an asset, is increased with a debit 5 Revenue is increased with a credit Provided services on account to customers. $ 30,000 The asset, Accounts Receivable (representing amounts due from customers for work already rendered) is increased, which is matched with an increase in Revenues/Income/Equity. Accounts Receivable, an asset, is increased with a debit 5 Revenue is increased with a credit Collected amounts due from customers for work previously rendered. $ 20,000 Cash is increased and Accounts Receivable is decreased, resulting in no change in total assets. Cash, an asset, is increased with a debit 5 Accounts Receivable, an asset, is decreased with a credit Used up supplies in the process of providing services to customers. $   3,000 An existing asset, Supplies, is used up and must be removed from the Asset account. This represents an Expense (expenses decrease income and therefore equity). Supplies Expense, an expense, is increased with a debit 5 Supplies, an asset, is decreased with a credit Bought additional supplies on account. $    2,500 Supplies increase, as does the Accounts Payable liability account. Supplies, an asset, is increased with a debit 5 Accounts Payable, a liability, is increased with a Credit Paid amounts due on outstanding Accounts Payable. $    6,000 Cash and Accounts Payable are both decreased. Accounts Payable, a liability, is decreased with a debit 5 Cash, an asset, is decreased with a credit Issued additional shares of stock. $12,000 Cash and the Capital Stock account are Cash, an asset, is increased with both increased by the same amount. a debit 5 Capital Stock, an equity account, is increased with a credit Purchased land for cash ($20,000) and incurred a $55,000 loan. $75,000 Land (an asset) goes up by $75,000. This is offset a $20,000 reduction in Cash. The balancing amount of $55,000 is reflected as increase in the liability account Loan Payable. Land, an asset, is increased with a debit for $75,000 5 Cash, an asset, is decreased with a credit for $20,000, and Loan Payable, a liability, is increased with a Credit for $55,000 Paid wages to employees. $    7,000 Cash is decreased, as is Income/Equity via the recording of Wages Expense. Wage Expense, an expense, is increased with a debit 5 Cash, an asset, is decreased with a credit Paid dividends to shareholders. $      5,000 Cash is decreased and the Dividends Dividends are increased with account is increased by the same a debit 5 Cash, an asset, is amount (which causes a decrease in decreased with a credit Retained Earnings/Equity). 35 waL80144_02_c02_027-052.indd 9 8/29/12 2:43 PM waL80144_02_c02_027-052.indd 10 50,000 Cash Dr 30,000 $ 125,000 $ $ (increase income, thus equity) (decrease income, thus equity) – Cr 30,000 Cr 10,000 Dr 3,000 Retained Earnings $ 140,000 (decrease equity) Stockholders’ Equity Dividends Revenues Expenses – Dr 5,000 Cr 12,000 $ 50,000 (increase equity) Capital stock Ending balance $ 54,000 4,500 $ 95,000 $288,500 Total Assets $ 135,000 $ – $61,500 Total Liabilities 4,500 $ 57,000 – $ 62,000 $ $ 10,000 $30,000 Net Income $ 40,000 $227,000 Total Equity Ending retained earnings $30,000 – $5,000 = $25,000 Increase in retained earnings Plus beginning retained earnings 5,000 – + Dividends Cr (5,000) – Dr (6,000) 2,000 Cr 55,000 8,000 $ Cr 2,500 $ Loan payable Liabilities Accounts payable Dr 7,000 Dr 75,000 = Pay wages Cr (7,000) Buy land with Cr (20,000) cash and loan Additional investment Dr 12,000 – Dr 2,500 Buy supplies on account – Cr (3,000) Record use of supplies Pay on account Cr (6,000) Land 5,000 $ 20,000 Supplies Assets Accounts Receivable Collect account Dr 20,000 Cr (20,000) Services on account Services for cash Dr 10,000 Beginning balances $ Description Section 2.3 Transaction Analysis CHAPTER 2 You might have noticed that some transactions can impact more than just two accounts. This example included the purchase of land for cash and a loan payable. Nevertheless, these compound entries are still expected to balance. Exhibit 2.5 is a repeat of Exhibit 1.5 but revised to reflect debits and credits in lieu of pluses and minuses. Carefully note that debits equal credits within each row. Exhibit 2.5: S preadsheet for Clearview Window Washers for December 36 8/29/12 2:43 PM CHAPTER 2 Section 2.4 General Journal Pressing forward, you now have a basis to understand the fundamental way in which businesses process transactions into useful financial reports. It all begins with an analysis of transactions and their conversion into a debit and credit characterization. Obviously, this information must be systematically logged into the accounting records. Sometimes this occurs automatically, such as with a point-of-sale terminal. Other times, a specific human action initiates the recording activity. 2.4 General Journal Y ou are familiar with the concept of a journal. Perhaps you or someone you know keeps a daily journal of life’s events. Borrowing this concept and applying it to a business, the general journal is a log of the transactions engaged in by the business. However, rather than just describing transactions in narrative form (such as “collected Cash on an outstanding Account Receivable”), the journal includes this information in debit and credit form. This information is usually logged, or journalized, in chronological order. It is the starting point for collecting information about business activity and has been called the book of original entry. Exhibit 2.6 is an example journal page for Clearview Window Washers. The entries correspond to the activity described in Table 2.3. Also note that debits are customarily listed first within each journal entry and are left justified. Debits are naturally followed by credits and are right justified. These data and entries reflect a summary of all activity for December. More likely, a business’s journal will have an entry for each transaction. 37 waL80144_02_c02_027-052.indd 11 8/29/12 2:43 PM CHAPTER 2 Section 2.4 General Journal Exhibit 2.6: E xample journal entries for Clearview Window Washers General Journal Date Dec. 20X5 Accounts Page 1 Debit Credit 10,000 Cash Revenues 10,000 Dec. 20X5 Provided services for cash Accounts Receivable Revenues 30,000 Dec. 20X5 Provided services on account Cash Accounts Receivable 20,000 30,000 20,000 Collected outstanding receivable Dec. 20X5 3,000 Supplies Expense Supplies 3,000 Dec. 20X5 Used supplies from existing inventory Supplies Accounts Payable 2,500 Dec. 20X5 Purchased supplies on account Accounts Payable Cash 6,000 Dec. 20X5 Paid outstanding account payable Cash Capital Stock Dec. 20X5 Issued capital stock for cash Land Cash Loan Payable 2,500 6,000 12,000 12,000 75,000 20,000 55,000 Dec. 20X5 Purchased land for cash and loan Wages Expense Cash 7,000 Dec. 20X5 Issued capital stock for cash Dividends Cash 5,000 7,000 5,000 Paid dividends to shareholders 38 waL80144_02_c02_027-052.indd 12 8/29/12 2:43 PM CHAPTER 2 Section 2.5 Chart of Accounts 2.5 Chart of Accounts Y ou may be wondering if there is a fixed set of accounts to choose from. The answer is clearly no. Each company’s unique business circumstances will dictate the particular accounts that are logical and useful to support its accounting system. Should the need for a new account arise, it is a simple matter to add an additional account. Furthermore, it is common to assign a unique number to each account. The numbering system is usually called a chart of accounts. It is common for the numbering scheme to communicate information about the nature of accounts. For example, all assets may be numbered in the 1000s, liabilities in the 2000s, and so on. This allows logical sorting of data. Every company’s number system is likely to be unique. The assigned numbers are arbitrary, like zip codes, and merely a tool of convenience for classifying data. Assume that Clearview’s chart of accounts appears as Table 2.4 shows. Table 2.4: Clearview chart of accounts Cash $1,000 Accounts Receivable 1,010 Supplies 1,020 Land 1,030 Accounts Payable 2,010 Loan Payable 2,020 Capital Stock 3,000 Retained Earnings 3,100 Dividends 6,000 Revenue 4,010 Supplies Expense 5,010 Wage Expense 5,020 Posting the General Ledger At this point, you may be wondering how to prepare financial statements from the journal’s information. The short answer is that you would not! You cannot simply look at the journal, for example, and know how much cash Clearview has on hand. The data from the journal must be compiled (or sorted) into relevant accounts. This process is usually called posting, the process of transferring data from the journal into the general ledger. Think of the ledger as a notebook containing a separate page for each account. The Cash account in the general ledger might look like that shown in Exhibit 2.7. 39 waL80144_02_c02_027-052.indd 13 8/29/12 2:43 PM CHAPTER 2 Section 2.5 Chart of Accounts Exhibit 2.7: S ample page from the general ledger for the Cash account Account: Cash Date Description Debit Credit Balance $ Dec. 20X5 Balance forward Dec. 20X5 Provided services for cash Dec. 20X5 Collected receivable Dec. 20X5 Paid outstanding accounts payable Dec. 20X5 Issued capital stock Dec. 20X5 Purchased land Dec. 20X5 Dec. 20X5 $ 50,000 60,000 10,000 80,000 20,000 $ 6,000 74,000 86,000 12,000 20,000 66,000 Paid wages 7,000 59,000 Paid dividends 5,000 54,000 Notice that beginning balance of Cash is updated for each transaction. A similar process would apply to each account. In other words, every entry in the journal is posted in the appropriate cell in the ledger. This process enables you to review the ledger and determine the balance for each account. Exhibit 2.8 shows a comprehensive illustration for Clearview’s general journal and ledger for December. 40 waL80144_02_c02_027-052.indd 14 8/29/12 2:43 PM waL80144_02_c02_027-052.indd 15 Dec. 20X5 Paid wages Paid dividends Dec. 20X5 Dec. 20X5 Date 5,000 5,000 Issued capital stock for cash Dividends Cash Dec. 20X5 Dec. 20X5 Date Dec. 20X5 Description Collected receivable on account Provided services Balance forward Purchased supplies Used supplies Balance forward Description Account: Supplies Dec. 20X5 Dec. 20X5 Dec. 20X5 Dec. 20X5 7,000 Paid dividends to shareholders Purchased land Account: Accounts Receivable Issued capital stock accounts payable Paid outstanding Collected receivable for cash Provided services Dec. 20X5 55,000 7,000 Description Balance forward Dec. 20X5 Dec. 20X5 Dec. 20X5 Dec. 20X5 Dec. 20X5 Date Account: Cash 20,000 Purchased land for cash and loan Wages Expense Cash 75,000 12,000 6,000 Dec. 20X5 Issued capital stock for cash Land Cash Loan Payable Paid outstanding account payable Cash Capital Stock Dec. 20X5 Dec. 20X5 6,000 Purchased supplies on account Accounts Payable Cash 12,000 2,500 2,500 Used supplies from existing inventory Supplies Accounts Payable Dec. 20X5 3,000 3,000 Collected outstanding receivable 20,000 20,000 Provided services on account Cash Accounts Receivable 10,000 Credit 30,000 30,000 10,000 Debit Accounts Receivable Revenues Provided services for cash Cash Revenues Accounts Page 1 Supplies Expense Supplies Dec. 20X5 Dec. 20X5 Dec. 20X5 Dec. 20X5 Date General Journal $ $ $ 2,500 Debit 30,000 Debit 12,000 20,000 10,000 Debit $ $ $ 3,000 Credit 20,000 $ 54,000 5,000 4,500 2,000 5,000 Balance 135,000 155,000 125,000 Balance 59,000 Credit 66,000 86,000 74,000 80,000 60,000 50,000 Balance 7,000 $ $ 20,000 6,000 Credit Section 2.5 Chart of Accounts CHAPTER 2 Exhibit 2:8: C  learview Window Washing’s general journal and ledger 41 8/29/12 2:43 PM CHAPTER 2 Section 2.5 Chart of Accounts A properly designed system of journals and ledgers will usually include a numeric crossreferencing system that allows you to trace journal entries to the ledger and vice versa. In a manual system, check marks may also indicate that a particular transaction has been posted to the ledger. Without these marks, it would be very easy to fail to post a transaction or even to post the same transaction twice. Computerized posting somewhat eliminates this particular risk. Sometimes a unique number is assigned to each transaction, further improving the ability to trace transactions through the entire accounting system. However accomplished, a company should maintain an indexing system to allow a user to trace amounts back to the original transaction in the journal and to be certain that each transaction was appropriately processed into the ledger. Trial Balance Ledger balances are often tallied up to verify that debits equal credits. This tally can be illustrated in a trial balance. The trial balance is not a financial statement; it is just a listing of accounts and their respective balances (Exhibit 2.9). The trial balance can be used to prepare financial statements. For instance, amounts in the trial balance shown can be displayed in financial statement format and would appear identical to those illustrated in Chapter 1 (Exhibits 1.121.3). You should take a moment to compare the trial balance to those financial statements. Exhibit 2.9: T rial balance sheet for Clearview Window Washers Clearview Window Washers Trial Balance December 31, 20X5 Debits Credits $ 54,000 135,000 4,500 95,000 Cash Accounts receivable Supplies Land Accounts payable Loans payable Capital stock Retained earnings (beginning) Dividends Revenue Supplies expense Wages expense $ 4,500 57,000 $ 62,000 140,000 $ 5,000 40,000 3,000 7,000 $ 303,500 – $ 303,500 Review of the Sequence of Transaction Recording To review, notice that the accounting sequence has entailed (1) analyzing each transaction to determine the accounts involved and whether those accounts need to be debited or credited, (2) preparing a journal entry for the transaction, and (3) occasional posting of journal entries to the ledger. This process sounds pretty mundane, and you may be wondering how anyone can think of accounting work as exciting, analytical, or dynamic. 42 waL80144_02_c02_027-052.indd 16 8/29/12 2:43 PM CHAPTER 2 Section 2.5 Chart of Accounts Dismiss the thought. What has been described is really just the beginning of the accounting process. It has been pointed out that much of this work lends itself to automation. The process just described is bookkeeping, not accounting. Bookkeeping is the skill or process of recording transactions; accounting goes much further. To extend this thought, you should now begin to appreciate that much of what has been shown thus far is based only on the recording of observed transactions. Other transactions or events may have occurred but not yet triggered into the accounting system. For instance, the business may have done some work that has not yet been billed. Utilities might have been consumed, but no bill has been received. Further, some accounts may need to be updated. Recall the earlier reference to accumulated depreciation. As time passes, additional depreciation occurs and should be recorded. There is no automatic triggering or observable transaction for this process. To prepare truly correct financial statements, additional accounting steps are needed to adjust the various accounts within the financial statements. This adjustment process will be demonstrated in Chapter 3. There you will be introduced to accrual accounting concepts and income measurement processes. That is the point where you will begin to understand where true accounting thought begins and bookkeeping ends. First, however, there are few important loose ends to consider. There is no particular order to the following discussion. They are simply additional important points that you need to know about. A Balanced Trial Balance: No Guarantee of Correctness The trial balance proves that debits equal credits. This suggests that all journal entries were in balance and fully posted to the ledger. However, the equality is no guarantee that there are no errors. If the same transaction was recorded twice or part or all of an entry was posted to the wrong accounts, the trial balance would still be in balance. If a transaction was not recorded at all or some form of end-of-period adjustment was omitted, a trial balance would also fail to reveal these events. So, the trial balance is a great tool to identify some but not all potential problems within the accounting system. Numerous other processes are used to verify the correctness of accounts. For example, the Cash account should additionally be verified by periodic bank reconciliations. (Later chapters will introduce methods and procedures accountants deploy as part of the financial statement assurance process.) Special Journals This text illustrates all journal entries as occurring within the general journal. However, some computerized and manual accounting systems will subdivide some journalizing activity into multiple special journals. For example, all cash outflows might be recorded in a cash disbursements journal. Conversely, cash receipts might all be recorded in a cash receipts journal. Other special journals can be designed to capture sales on account, payroll, purchases on account, and other redundant activities. The benefits of special journals are many. For example, payroll records can be consolidated and housed in a single accounting record. Recording all sales on account within a specially designed journal can be helpful when billing customers. Additionally, special journals can reduce the amount of processing and posting that is necessary within a manual 43 waL80144_02_c02_027-052.indd 17 8/29/12 2:43 PM CHAPTER 2 Section 2.7 Thinking About Automation system. Consider that all cash receipts involve a debit to Cash. Thus, it would be possible to post only a single debit to Cash for the aggregate of all transactions listed within the cash receipts journal. Basically, special journals are optional tools that can streamline the components of the accounting system. Strict reliance on only a general journal can result in an excessively voluminous set of accounting records. Nevertheless, any transaction can always be recorded in a general journal, and the general journal is supplemented by special journals (but not replaced). 2.6 Source Documents A company must also be careful to maintain source documents. Most transactions are represented by a source document, which provides tangible evidence of the existence and nature of a transaction. Cash disbursements typically occur by issuing a check or bank transfer. Sales to customers are usually accompanied by a receipt or invoice. There are numerous types of source documents. They usually trigger the recording of a transaction and are often analyzed to determine how a transaction has impacted specific accounts. Source documents should be preserved as evidence of transactions. To provide information about a past transaction, looking back at a source document is frequently necessary. Electronic imaging has facilitated the ability to retain such documents going back many years. The real trick is not in retaining the documents but to do so in such a way that they can be found. Thus, dating, numbering, and cataloging source documents are all crucial. Accountants may help design and implement a strong information system, and the journal/ledger system will usually link into the source document archives of modern information systems. The days of storing old documents in numbered boxes stacked deep within an old warehouse are rapidly fading away. 2.7 Thinking About Automation T hroughout this chapter, a number of references have been made to computerized accounting. Most accounting software has a number of features in common. For starters, programmers know the need to simplify and automate data entry. This invariably includes attempts to integrate the journalizing process with the origin of the transaction itself. Earlier, it was noted that transactions entered in a point-of-sale terminal may also link into the accounting system. Inventory movement may be tracked with radio frequency identification chips, and that tracking process can link into the company accounting system. Time clocks for tracking employee labor-hours can become input devices for payroll accounting. Automated systems are usually subdivided into modules. There may a separate module for the revenue cycle, which serves to track all sales and collections. Another module can relate only to payroll. Numerous other modules can be deployed. These modules enable subdivision of processing to persons especially familiar with selected portions of a business. Individual modules may be password protected. For instance, a payroll accountant would not need to be privy to sales activity and vice versa. The consolidated view of the entire business and the ability to view aggregated reports and financial statements should be limited to only those with a need or right to know. Software allows this important control feature. 44 waL80144_02_c02_027-052.indd 18 8/29/12 2:43 PM CHAPTER 2 Section 2.8 Critical Thinking About Debits and Credits Accounting software is also designed to be user friendly. It usually includes click lists, drag-and-drop tools, and auto-complete functions that allow users to quickly select options and enter data, similar to Exhibit 2.10. Exhibit 2.10: Typical accounting software Actions List: + Create an Invoice » Receive a Payment $ Record an Expense √ View Statements ∞ Manage Accounts × Generate a Report File Edit View Help Debits 502 Utilities Expense 201 Accounts Payable Credits $1,000.00 $1,000.00 $1,000.00 $1,000.00 Entry in balance Record entry #756 2.8 Critical Thinking About Debits and Credits E arlier you were asked to clear your mind of any preconceived notions about debits and credits. Let’s now try to make sense of how the terms are sometimes used in day-to-day commerce. If a bank informs you that they are crediting your account, they are increasing your account. Bear in mind that your account is reflected as a liability on a bank’s balance sheet because they owe you the money that you deposited with them. In other words, when they credit your account, they are increasing their liability to you, and you have more funds on deposit. Conversely, if you use a debit card when you spend, your cash in the bank is decreasing (and the bank is debiting your account). When you fill out a credit application, you are asking for authorization to increase your debt. Each use of the terms debit and credit can logically be traced back to the effect on one party’s financial statements, and those effects correspond to the debit and credit rules you learned in this chapter. 45 waL80144_02_c02_027-052.indd 19 8/29/12 2:43 PM CHAPTER 2 Concept Check Concept Check The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.) 1. A credit is used in accounting to a. increase an asset account. b. decrease a liability account. c. increase a revenue account. d. increase an expense account. 2. Popcorn  Inc. recently purchased some office equipment on account. The proper entry would involve a a. debit to Office Expense and credit to Accounts Payable. b. debit to Office Equipment and credit to Accounts Payable. c. debit to Office Equipment and credit to Accounts Receivable. d. debit to Accounts Payable and credit to Office Equipment. 3. Which of the following statements is false? a. Transactions are initially recorded in the journal and then transferred to the general ledger. b. A company’s accounts are housed in the general ledger. c. Posting is a process by which accounting information is transferred from one record to another. d. A source document is initially translated into a debit and credit format in the general ledger. 4. The trial balance a. is prepared at the beginning of an accounting period. b. checks the equality of debits and credits contained in the general ledger. c. is prepared by extracting information directly from the journal. d. is a formal financial statement like the balance sheet. 5. Sofa Company’s trial balance will not balance if a. the $2,900 debit balance in the Cash account is entered in the trial balance’s credit column. b. the bookkeeper accidentally forgets to record a payment of rent in the journal. c. a credit to Accounts Receivable is posted as a credit to Accounts Payable. d. a $460 purchase of equipment is accidentally entered in the accounting records at $640. 46 waL80144_02_c02_027-052.indd 20 8/29/12 2:43 PM CHAPTER 2 Critical Thinking Questions Key Terms account The master record that is maintained for each individual financial statement asset, liability, equity, revenue, expense, or dividend component. general ledger The collection of all accounts. posting The process of transferring data from the journal into the general ledger. bookkeeping The skill or process of recording of transactions. source document Tangible evidence of the existence and nature of a transaction. chart of accounts A numbering system in which a unique number is assigned to each account. special journal A subdivision of a general journal. T-account A device that is used to demonstrate the impact of certain transactions and events. credit The action of recording a decrease to an asset, expense, or divided account. debit The action of recording an increase to an asset, expense, or divided account. trial balance A listing of accounts and their respective balances. general journal A log of the transactions engaged in by the business. Critical Thinking Questions 1. Briefly explain how a typical accounting system operates. 2. What is a general ledger? 3. In terms of debits and credits, liabilities are decreased by ________________, assets are increased by _________________, and revenues are increased by ___________________. 4. Explain the relationship between the accounting equation and normal account balances. 5. Les Howard accidentally debited an expense account rather than an asset account. As a result of this error, determine whether the following items will be overstated, understated, or unaffected. Total assets will be _________________. Total expenses will be _________________. Net income will be _________________. 6. What is the purpose of a trial balance? 7. What types of errors will not affect the equality of the trial balance totals? 8. A $750 debit to Cash was accidentally posted as a credit to Accounts Payable. a. Will the trial balance be in balance? b. If your answer to part (a) is no, what will be the difference between the debit and credit totals? 47 waL80144_02_c02_027-052.indd 21 8/29/12 2:43 PM CHAPTER 2 Exercises Exercises 1. R  ecognition of normal balances. The following items appeared in the accounting records of Triguero’s, a retail music store that also sponsors concerts. Classify each item as an asset, liability, revenue, or expense from the company’s viewpoint. Also indicate the normal account balance of each item. a. The albums, tapes, and CDs held for sale to customers b. A long-term loan owed to Citizens’ Bank c. Promotional costs to publicize a concert d. Daily receipts for merchandise sold e. Amounts due from customers f. Land held as an investment g. A new fax machine purchased for office use h. Amounts to be paid in 10 days to suppliers i. Amounts paid to a mall for rent 2. G  eneral journal and general ledger content. St. James Services uses a general journal and general ledger to process transactions. Assume that the volume of transactions has grown in recent months and that all posting procedures have already been performed. A manager has requested that you provide the following data: a. The total amounts that clients owe the firm as of May 31 b. The accounts that were increased or decreased by a particular transaction on a specific date c. The total cash received during May d. The reason for a cash disbursement on May 14 e. A dated listing of all decreases to the Accounts Payable account during the month Evaluate the data requests of the manager independently and determine whether the requests can be answered most efficiently by a review of the company’s general journal or the general ledger. 3. B  asic journal entries. The following April transactions pertain to the Jennifer Royall Company: 4/1: Received cash of $15,000 and land valued at $10,000 from Jennifer Royall as an investment in the business. 4/5: Provided $1,200 of services to Jason Ratchford, a client. 4/5: Ratchford agreed to pay $800 in 15 days and the remaining amount in May. 4/9: Paid $250 in salaries to an employee. 4/19: Acquired a new computer for $3,200; Royall will pay the dealer in May. 4/20: Collected $800 from Jason Ratchford for services provided on April 5. 4/24: Borrowed $7,500 from Best Bank by securing a 6-month loan. 48 waL80144_02_c02_027-052.indd 22 8/29/12 2:43 PM CHAPTER 2 Problems Prepare journal entries (and explanations) to record the preceding transactions and events. 4. T  rial balance preparation. Brighton Company began operation on March 1 of the current year. The following account balances were extracted from the general ledger on March 31; all accounts have normal balances. Accounts Payable Accounts Receivable Advertising Expense Bob Brighton, Capital Cash Fees Earned $ 12,000 8,800 5,700 30,000 22,500 18,900 Interest Expense Land Loan Payable Salaries Expense Utilities Expense $ 300 ? 26,000 11,100 700 a. Determine the cost of the company’s land by preparing a trial balance. b. Determine the firm’s net income for the period ending March 31. 5. T  rial balance errors. You are reviewing the month-end trial balance for Schirmer Enterprises and discover various errors [parts (a)2(f)]. Identify the effect of the errors on the trial balance by using the following codes. Where appropriate, indicate the amount of the error. 1—Debits will exceed credits by $___________. 2—Credits will exceed debits by $___________. 3—Debits will be equal to credits. a. Failed to record $1,000 of service revenue charged to customers at month-end. b. Incorrectly understated the balance in the Cash account by $2,500. c. Recorded the collection of $400 on account as a debit to Cash and a debit to Accounts Receivable. d. Recorded  the $5,000 balance of Equipment in the credit column of the trial balance. e. Recorded payment of the month’s $700 utility bill as a $700 debit to Utilities Expense and a $70 credit to Cash. f. Recorded a $3,000 payment on account as a debit to Repairs Expense and a credit to Cash. Problems 1. T  ransaction analysis and trial balance preparation. The T-accounts that follow were taken from the books of Miller Data Processing on December 31 of the current year. Letters in the accounts reference specific transactions of the firm. Cash (a) 35,000 (d) 3,000 (b) 10,000 (h) 1,500 (f) 8,000 (j) 800 (i) 400 49 waL80144_02_c02_027-052.indd 23 8/29/12 2:43 PM CHAPTER 2 Problems Accounts Receivable (c) 14,000 (f) 8,000 Computer Equipment (b) 26,000 (g) 7,000 (e) 9,000 Accounts Payable (g) 7,000 (e) 9,000 (j) 800 Loan Payable (h) 1,500 (a) 35,000 Fees Earned (c) 14,000 Miller, Capital (b) 36,000 Advertising Expense Utilities Expense (d) 2,000 (d) 1,000 (i) 400 a. Write a brief explanation of each of the transactions (a)2(j). b. Determine the balance in each account and prepare a trial balance. 2. E  ntry and trial balance preparation. Lee Adkins is a portrait artist. The following schedule represents Lee’s combined chart of accounts and trial balance as of May 31. 110 120 130 140 210 310 320 410 510 520 540 Cash Accounts Receivable Equipment and Supplies Studio Accounts Payable Lee Adkins, Capital Lee Adkins, Drawing Professional Fees Advertising Expense Salaries Expense Utilities Expense $ 2,700 12,100 2,800 45,000 $ 2,600 57,400 30,000 39,000 2,300 2,100 2,000 $99,000 $99,000 The general ledger also revealed account no. 530, Legal and Accounting Expense. The following transactions occurred during June: 6/2: Collected $7,500 on account from customers. 6/7: Sold 25% of the equipment and supplies to a young artist for $700. 6/10:  eceived a $500 bill from the accountant for preparing last quarter’s R financial statements. 6/15: Paid $2,100 to creditors on account. 6/27: Processed a $1,000 cash withdrawal for personal use. 6/30: Billed a customer $3,000 for a portrait painted this month. 50 waL80144_02_c02_027-052.indd 24 8/29/12 2:43 PM CHAPTER 2 Problems a. Record the necessary journal entries for June on page 2 of the company’s general journal. b. Open running balance ledger accounts by entering account titles, account numbers, and May 31 balances. c. Post the journal entries to the ledger. d. Prepare a trial balance as of June 30. 3. J ournal entry preparation. On January 1 of the current year, MuniServ began operations with $100,000 cash. The cash was obtained from an owner (Peter Houston) investment of $70,000 and a $30,000 bank loan. Shortly thereafter, the company acquired selected assets of a bankrupt competitor. The acquisition included land ($15,000), a building ($40,000), and vehicles ($10,000). MuniServ paid $45,000 at the time of the transaction and agreed to remit the remaining balance due of $20,000 (an account payable) by February 15. During January, the company had additional cash outlays for the following items: Purchases of store equipment $4,600 Loan payment, including $100 interest Salaries expense 500 2,300 Advertising expense 700 The January utilities bill of $200 was received on January 31 and will be paid on February 10. MuniServ rendered services to clients on account, amounting to $9,400. All customers have been billed; by month-end, $3,700 had been received in settlement of account balances. Instructions a. Present journal entries that reflect MuniServ’s January transactions, including the $100,000 raised from the owner investment and loan. b. Compute the total debits, total credits, and ending balance that would be found in the company’s Cash account. c. Determine the amount that would be shown on the January 31 trial balance for Accounts Payable. Is the balance a debit or a credit? 51 waL80144_02_c02_027-052.indd 25 8/29/12 2:43 PM waL80144_02_c02_027-052.indd 26 8/29/12 2:43 PM
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