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.
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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
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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.
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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).
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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
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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.
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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.
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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.
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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).
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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
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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.
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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
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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.
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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.
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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
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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.
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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
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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.
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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.
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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.
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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?
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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.
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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
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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.
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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?
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