CHAPTER 3
The Accounting Information System

Accidents Happen

How organized are you financially? Take a short quiz. Answer yes or no to each question:

• Does your wallet contain so many cash machine receipts that you’ve been declared a walking fire hazard?
• Do you wait until your debit card is denied before checking the status of your funds?
• Do you verify the accuracy of your bank account about as often as you clean the space behind your refrigerator?

If you think it is hard to keep track of the many transactions that make up your life, imagine how difficult it is for a big corporation to do so. Not only that, but now consider how important it is for a big company to have good accounting records, especially if it has control of your life savings. MF Global Holdings Ltd was such a company. As a large investment broker, it held billions of dollars of investments for clients. If you had your life savings invested at MF Global, you might be slightly displeased if you heard this from one of its representatives: “You know, I kind of remember an account for someone with a name like yours—now what did we do with that?”

Unfortunately, that is almost exactly what happened to MF Global’s clients shortly before it filed for bankruptcy. During the days immediately following the bankruptcy filing, regulators and auditors struggled to piece things together. In the words of one regulator, “Their books are a disaster … we’re trying to figure out what numbers are real numbers.” One company that considered buying an interest in MF Global walked away from the deal because it “couldn’t get a sense of what was on the balance sheet.” That company said the information that should have been instantly available instead took days to produce.

It now appears that MF Global did not properly segregate customer accounts from company accounts. And, because of its sloppy recordkeeping, customers were not protected when the company had financial troubles. Total customer losses were approximately $1 billion. As you can see, accounting matters!

Source: S. Patterson and A. Lucchetti, “Inside the Hunt for MF Global Cash,” Wall Street Journal Online (November 11, 2011).

Accounting Transactions

To use an accounting information system, you need to know which economic events to recognize (record). Not all events are recorded and reported in the financial statements. For example, suppose Zoom Video Communications hired a new employee and purchased a new computer. Are these two events entered in its accounting records? The first event would not be recorded, but the second event would.

• We call economic events that require recording in the financial statements accounting transactions.
• An accounting transaction occurs when assets, liabilities, or stockholders’ equity items change as a result of some economic event.
• When Zoom hires a new employee, its assets, liabilities, and stockholders’ equity are not affected. But when it purchases a computer, Zoom records the change in the company’s assets.

Illustration 3.1 summarizes the decision process companies use to decide whether or not to record economic events.

Analyzing Transactions

Recall the basic accounting equation:

In this chapter, you will learn how to analyze transactions in terms of their effect on assets, liabilities, and stockholders’ equity. Transaction analysis is the process of identifying the specific effects of economic events on the accounting equation (see Decision Tools).

The accounting equation must always balance. Each transaction has a dual (double-sided) effect on the equation. For example, if an individual asset is increased, there must be a corresponding:

• Decrease in another asset, or
• Increase in a specific liability, or
• Increase in stockholders’ equity.

Two or more items could be affected when an asset is increased. For example, if a company purchases a computer for $10,000 by paying $6,000 in cash and signing a note for $4,000, one asset (equipment) increases $10,000, another asset (cash) decreases $6,000, and a liability (notes payable) increases $4,000. The result is that the accounting equation remains in balance—assets increased by a net $4,000 and liabilities increased by $4,000, as shown below.

Illustration 1.10 presented the financial statements for Sierra Corporation for its first month. You should review those financial statements at this time. To illustrate how economic events affect the accounting equation, we will examine the events affecting Sierra during its first month.

In order to analyze the transactions for Sierra, we will expand the basic accounting equation. This allows us to better illustrate the impact of transactions on stockholders’ equity.

• Recall that stockholders’ equity is comprised of two parts: common stock and retained earnings.
• Common stock is affected when the company issues new shares of stock in exchange for cash.
• Retained earnings is increased when the company recognizes revenue, and decreased when the company incurs expenses or pays dividends.

Illustration 3.2 shows the expanded equation.

To demonstrate the effect that each transaction has on particular financial statements, we analyze each of Sierra’s transactions using the tabular analysis shown in Illustration 3.3.

• Amounts that are reported on the balance sheet are shaded in yellow, income statement items in blue, and dividends (shown on the statement of retained earnings) in gray.
• Explanations for income statement items are reported in the blue section on the right-hand side.
• The green section on the left-hand side indicates whether cash flows increased, decreased, or were not affected.

Event (1). Investment of Cash by Stockholders On October 1, cash of $10,000 is invested in the business by investors in exchange for $10,000 of common stock. This event is an accounting transaction that results in an increase in both assets and stockholders’ equity.

Basic Analysis: The asset Cash is increased $10,000; stockholders’ equity (specifically Common Stock) is increased $10,000.

The equation is in balance after the issuance of common stock. Keeping track of the source of each change in stockholders’ equity is essential for later accounting activities. In particular, items recorded in the revenue and expense columns are used for the calculation of net income.

Event (2). Note Issued in Exchange for Cash On October 1, Sierra borrowed $5,000 from Castle Bank by signing a 3-month, 12%, $5,000 note payable. This transaction results in an equal increase in assets and liabilities. The specific effect of this transaction and the cumulative effect of the first two transactions are as follows.

Basic Analysis: The asset Cash is increased $5,000; the liability Notes Payable is increased $5,000.

Total assets are now $15,000, and liabilities plus stockholders’ equity also total $15,000.

Event (3). Purchase of Equipment for Cash On October 2, Sierra purchased equipment by paying $5,000 cash to Superior Equipment Sales Co. This transaction results in an equal increase and decrease in Sierra’s assets.

Basic Analysis: The asset Equipment is increased $5,000; the asset Cash is decreased $5,000.

The balance in total assets did not change; one asset account decreased by the same amount that another increased. The total assets are still $15,000, and liabilities plus stockholders’ equity also still total $15,000.

Event (4). Receipt of Cash in Advance from Customer On October 2, Sierra received a $1,200 cash advance from R. Knox, a client. Sierra received cash (an asset) for guide services for multi-day trips that it expects to complete in the future.

• Although Sierra received cash, it does not record revenue until it has performed the work.
• In some industries, such as the magazine and airline industries, customers are expected to prepay. These companies have a liability to the customer until they deliver the magazines or provide the flight.
• When the company eventually provides the product or service, it records the revenue.

Since Sierra received cash prior to performance of the service, Sierra has a liability for the work due.

Basic Analysis: The asset Cash is increased $1,200; the liability Unearned Service Revenue is increased $1,200 because the service has not been performed yet. That is, when an advance payment is received, unearned revenue (a liability) should be recorded in order to recognize the obligation that exists.

Event (5). Services Performed for Cash On October 3, Sierra received $10,000 in cash (an asset) from Copa Company for guide services performed for a corporate event. Guide service is the principal revenue-producing activity of Sierra. Revenue increases stockholders’ equity. This transaction, then, increases both assets and stockholders’ equity.

Basic Analysis: The asset Cash is increased $10,000; the revenue account Service Revenue is increased $10,000.

Often companies perform services “on account.” That is, they perform services for which they are paid at a later date.

• Revenue, however, is recorded when services are performed.
• Therefore, revenues would increase when services are performed, even though cash has not been received.
• Instead of receiving cash, the company receives a different type of asset, an account receivable. Accounts receivable represent the right to receive payment at a later date.

Suppose that Sierra had performed these services on account rather than for cash. This event would be reported using the accounting equation as follows.

Later, when Sierra collects the $10,000 from the customer, Accounts Receivable decreases by $10,000, and Cash increases by $10,000.

Note that in this case, revenues are not affected by the collection of cash. Instead Sierra records an exchange of one asset (Accounts Receivable) for a different asset (Cash).

Event (6). Payment of Rent On October 3, Sierra paid its office rent for the month of October in cash, $900 (see Helpful Hint). This rent payment is a transaction that results in a decrease in an asset, cash, as well as a decrease in stockholders’ equity.

• Rent is a cost incurred by Sierra in its effort to generate revenues.
• Rent is treated as an expense because it pertains only to the current month.
• Expenses decrease stockholders’ equity.

Note that although Rent Expense increases, it is shown as a negative number in the accounting equation because expenses decrease retained earnings, which in turn decreases stockholders’ equity. Overall, assets (cash) decrease by $900 and stockholders’ equity decreases by $900, thereby keeping the accounting equation in balance.

Basic Analysis: The expense Rent Expense is increased $900 because the payment pertains only to the current month and results in a decrease to Retained Earnings; the asset Cash is decreased $900.

Event (7). Purchase of Insurance Policy for Cash On October 4, Sierra paid $600 for a one-year insurance policy that will expire next year on September 30. Payments of expenses that will benefit more than one accounting period are identified as assets called prepaid expenses or prepayments.

Basic Analysis: The asset Cash is decreased $600; the asset Prepaid Insurance is increased $600.

The balance in total assets did not change; one asset account decreased by the same amount that another increased.

Event (8). Purchase of Supplies on Account On October 5, Sierra purchased an estimated three months of supplies on account from Aero Supply for $2,500. In this case, “on account” means that the company receives goods or services that it will pay for at a later date. This transaction increases both an asset (supplies) and a liability (accounts payable).

Basic Analysis: The asset Supplies is increased $2,500; the liability Accounts Payable is increased $2,500.

Event (9). Hiring of New Employees On October 9, Sierra hired four new employees to begin work on October 15. Each employee will receive a weekly salary of $500 for a five-day work week, payable every two weeks. Employees will receive their first paychecks on October 26. On the date Sierra hires the employees, there is no effect on the accounting equation because the assets, liabilities, and stockholders’ equity of the company have not changed.

Basic Analysis: An accounting transaction has not occurred. There is only an agreement that the employees will begin work on October 15. (See Event (11) for the first payment.)

Event (10). Payment of Dividend On October 20, Sierra paid a $500 cash dividend (see Helpful Hint). Dividends are a reduction of stockholders’ equity but not an expense. Dividends are not included in the calculation of net income. Instead, a dividend is a distribution of the company’s assets to its stockholders, which is presented in the retained earnings statement.

Basic Analysis: Dividends is increased $500, which results in a decrease to Retained Earnings; the asset Cash is decreased $500.

Event (11). Payment of Cash for Employee Salaries Employees have worked two weeks, earning $4,000 in salaries, which were paid on October 26. Salaries and Wages Expense is an expense that reduces stockholders’ equity. In this transaction, both assets and stockholders’ equity are reduced.

Basic Analysis: The asset Cash is decreased $4,000; the expense Salaries and Wages Expense is increased $4,000, which results in a decrease to Retained Earnings.

Summary of Transactions

Illustration 3.4 summarizes the transactions of Sierra Corporation to show their cumulative effect on the basic accounting equation. It includes the transaction number in the first column on the left. The right-most column shows the specific effect of any transaction that affects revenues or expenses. Remember that Event (9) did not result in a transaction, so nothing is recorded for that event. The illustration demonstrates three important points:

1. Each transaction is analyzed in terms of its effect on assets, liabilities, and stockholders’ equity.
2. The two sides of the equation must always be equal.
3. The cause of each change in revenues or expenses must be indicated.

Debits and Credits

The term debit indicates the left side of an account, and credit indicates the right side.

• Sometimes abbreviations are used: Dr. for debit and Cr. for credit (see Helpful Hint). They do not mean increase or decrease, as is commonly thought.
• We use the terms debit and credit repeatedly in the recording process to describe where entries are made in accounts.
• For example, the act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account.

When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits. Note the position of the debit side and credit side in Illustration 3.5.

The procedure of recording debits and credits in an account is shown in Illustration 3.6 for the transactions affecting the Cash account of Sierra Corporation. The data are taken from the Cash column of the tabular summary in Illustration 3.4.

Every positive item in the tabular summary represents a receipt of cash; every negative amount represents a payment of cash. Notice that in the account form, we record the increases in cash as debits and the decreases in cash as credits. For example, the $10,000 receipt of cash (in blue) is debited to Cash, and the −$5,000 payment of cash (in red) is credited to Cash.

There are two main benefits from using the T-account form:

1. Having increases on one side and decreases on the other reduces recording errors.
2. The T-account form helps in determining the totals of each side of the account as well as the account balance. The balance is determined by netting the two sides (subtracting one amount from the other).

The account balance, a debit of $15,200, indicates that Sierra had $15,200 more increases than decreases in cash. That is, since it started with a balance of zero, it has $15,200 in its Cash account.

Debit and Credit Procedures

Each transaction must affect two or more accounts to keep the basic accounting equation in balance.

• Debits must equal credits.
• The equality of debits and credits provides the basis for the double-entry accounting system (see International Note).
• Under the double-entry system, the two-sided effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions.

The double-entry system also helps to ensure the accuracy of the recorded amounts and helps to detect errors such as those at MF Global as discussed in the Feature Story. If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits.

The double-entry system for determining the equality of the accounting equation is much more efficient than the plus/minus procedure used earlier. The following discussion illustrates debit and credit procedures in the double-entry system.

Dr./Cr. Procedures for Assets and Liabilities

In Illustration 3.6 for Sierra Corporation, increases in Cash—an asset—are entered on the left side, and decreases in Cash are entered on the right side.

• We know that both sides of the basic equation (Assets = Liabilities + Stockholders’ Equity) must be equal.
• It therefore follows that increases and decreases in liabilities have to be recorded opposite from increases and decreases in assets.
• Thus, increases in liabilities are entered on the right or credit side, and decreases in liabilities are entered on the left or debit side.

The effects that debits and credits have on assets and liabilities are summarized in Illustration 3.7.

Debits	Credits
Increase assets	Decrease assets
Decrease liabilities	Increase liabilities

Asset accounts normally show debit balances. That is, debits to a specific asset account should exceed credits to that account. Likewise, liability accounts normally show credit balances. That is, credits to a liability account should exceed debits to that account. The normal balances may be diagrammed as in Illustration 3.8.

Knowing which is the normal balance in an account may help when you are trying to identify errors (see Helpful Hint). For example, a credit balance in an asset account, such as Land, or a debit balance in a liability account, such as Salaries and Wages Payable, usually indicates errors in recording. Occasionally, however, an abnormal balance may be correct. The Cash account, for example, will have a credit balance when a company has overdrawn its bank balance by spending more than it has in its account. In automated accounting systems, the computer is programmed to flag violations of the normal balance and to print out error or exception reports. In manual systems, careful visual inspection of the accounts is required to detect normal balance problems.

Dr./Cr. Procedures for Stockholders’ Equity

Recall that stockholders’ equity is comprised of two parts: common stock and retained earnings. In the transaction events earlier in this chapter, you saw that revenues, expenses, and the payment of dividends affect retained earnings. Therefore, the subdivisions of stockholders’ equity are common stock, retained earnings, dividends, revenues, and expenses.

Common Stock Common stock is issued to investors in exchange for the stockholders’ investment.

• The Common Stock account is increased by credits and decreased by debits.
• When cash is invested in the business, Cash is debited and Common Stock is credited.

The effects of debits and credits on the Common Stock account are shown in Illustration 3.9.

Debits		Credits
Decrease Common Stock		Increase Common Stock

The normal balance in the Common Stock account may be diagrammed as in Illustration 3.10.

Retained Earnings Retained earnings is net income that is retained in the business.

• Retained Earnings represents the portion of stockholders’ equity that has been accumulated through the profitable operation of the company.
• Retained Earnings is increased by credits (for example, by net income) and decreased by debits (for example, by a net loss), as shown in Illustration 3.11.

Debits	Credits
Decrease Retained Earnings	Increase Retained Earnings

The normal balance for the Retained Earnings account may be diagrammed as in Illustration 3.12.

Dividends A dividend is a distribution by a corporation to its stockholders. The most common form of distribution is a cash dividend.

• Dividends result in a reduction of the stockholders’ claims on retained earnings.
• Because dividends reduce stockholders’ equity, increases in the Dividends account are recorded with debits.

As shown in Illustration 3.13, the Dividends account normally has a debit balance.

Revenues and Expenses When a company recognizes revenues, stockholders’ equity is increased. Revenue accounts are increased by credits and decreased by debits.

• Expenses decrease stockholders’ equity.
• Thus, expense accounts are increased by debits and decreased by credits.

The effects of debits and credits on revenues and expenses are shown in Illustration 3.14.

Debits	Credits
Decrease revenues	Increase revenues
Increase expenses	Decrease expenses

Credits to revenue accounts should exceed debits; debits to expense accounts should exceed credits. Thus, revenue accounts normally show credit balances, and expense accounts normally show debit balances. The normal balances may be diagrammed as in Illustration 3.15.

Stockholders’ Equity Relationships

Companies report the subdivisions of stockholders’ equity in various places in the financial statements:

• Common stock and retained earnings: in the stockholders’ equity section of the balance sheet.
• Dividends: on the retained earnings statement.
• Revenues and expenses: on the income statement.

Dividends, revenues, and expenses are eventually transferred to retained earnings at the end of the period. As a result, a change in any one of these three items affects stockholders’ equity. Illustration 3.16 shows the relationships of the accounts affecting stockholders’ equity.

Summary of Debit/Credit Rules

Illustration 3.17 summarizes the debit/credit rules and effects on each type of account.

• Study this diagram carefully. It will help you understand the fundamentals of the double-entry system (see Helpful Hint).
• No matter what the transaction, total debits must equal total credits accounting equation in balance.

The Recording Process

Although it is possible to enter transaction information directly into the accounts, few businesses do so. Practically every business uses these basic steps in the recording process (an integral part of the accounting cycle):

1. Analyze each transaction in terms of its effect on the accounts.
2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger.

The actual sequence of events begins with the transaction. Evidence of the transaction comes in the form of a source document, such as a sales slip, a check, a bill, or a cash register document (see Ethics Note). This evidence is analyzed to determine the effect of the transaction on specific accounts. The transaction is then entered in the journal. Finally, the journal entry is transferred to the designated accounts in the ledger. The sequence of events in the recording process is shown in Illustration 3.18.

The Journal

Transactions are initially recorded in chronological order in a journal before they are transferred to the accounts. For each transaction, the journal shows the debit and credit effects on specific accounts (see Helpful Hint).

Companies may use various kinds of journals, but every company has at least the most basic form of journal, a general journal. The journal makes three significant contributions to the recording process:

1. It discloses in one place the complete effect of a transaction.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors because the debit and credit amounts for each entry can be readily compared.

Entering transaction data in the journal is known as journalizing. To illustrate the technique of journalizing, let’s look at the first three transactions of Sierra Corporation in equation form.

1. On October 1, Sierra issued common stock in exchange for $10,000 cash:

   Assets	=	Liabilities	+	Stockholders’ Equity
   				Common
   Cash	=			Stock
   +$10,000				+$10,000	Issued stock

2. On October 1, Sierra borrowed $5,000 by signing a note:

   Assets	=	Liabilities	+	Stockholders’ Equity
   		Notes
   Cash	=	Payable
   +$5,000		+$5,000

3. On October 2, Sierra purchased equipment for $5,000:

   Assets			=	Liabilities	+	Stockholders’ Equity
   Cash	+	Equipment
   −$5,000		+$5,000

Sierra makes separate journal entries for each transaction. A complete entry consists of (1) the date of the transaction, (2) the accounts and amounts to be debited and credited, and (3) a brief explanation of the transaction. These transactions are journalized in Illustration 3.19.

Note the following features of the journal entries.

1. The date of the transaction is entered in the Date column.
2. The account to be debited is entered first at the left. The account to be credited is then entered on the next line, indented under the line above. The indentation differentiates debits from credits and decreases the possibility of switching the debit and credit amounts.
3. The amounts for the debits are recorded in the Debit (left) column, and the amounts for the credits are recorded in the Credit (right) column.
4. A brief explanation of the transaction is given (see Helpful Hint).

It is important to use correct and specific account titles in journalizing. Erroneous account titles lead to incorrect financial statements. Some flexibility exists initially in selecting account titles. The main criterion is that each title must appropriately describe the content of the account. For example, a company could use any of these account titles for recording the cost of delivery trucks: Equipment, Delivery Equipment, Delivery Trucks, or Trucks. Once the company chooses the specific title to use, however, it should record under that account title all subsequent transactions involving the account.

The Ledger

The record of all accounts maintained by a company and their amounts is referred to collectively as the ledger.

• The ledger provides the balance in each of the accounts as well as keeps track of changes in these balances.
• Companies may use various kinds of ledgers, but every company has a general ledger.
• A general ledger contains all the asset, liability, stockholders’ equity, revenue, and expense accounts, as shown in Illustration 3.20.

Whenever we use the term ledger in this text without additional specification, it will mean the general ledger.

Chart of Accounts

The number and type of accounts used differ for each company, depending on the size, complexity, and type of business. For example, the number of accounts depends on the amount of detail desired by management. The management of one company may want one single account for all types of utility expense. Another may keep separate expense accounts for each type of utility expenditure, such as gas, electricity, and water.

• A small corporation like Sierra Corporation will not have many accounts compared with a corporate giant like Ford Motor Company.
• Sierra may be able to manage and report its activities in 20 to 30 accounts, whereas Ford requires thousands of accounts to keep track of its worldwide activities.

Most companies list the names of the accounts in a chart of accounts. They may create new accounts as needed during the life of the business. Illustration 3.21 shows the chart of accounts for Sierra in the order that they are typically listed (assets, liabilities, stockholders’ equity, revenues, and expenses). Accounts shown in red are used in this chapter; accounts shown in black are explained in later chapters.

Posting

The procedure of transferring journal entry amounts to ledger accounts is called posting. This phase of the recording process accumulates the effects of journalized transactions in the individual accounts. Posting involves these steps:

1. In the ledger, enter in the appropriate columns of the debited account(s) the date and debit amount shown in the journal.
2. In the ledger, enter in the appropriate columns of the credited account(s) the date and credit amount shown in the journal.

The Recording Process Illustrated

Illustrations 3.22 through 3.32 show the basic steps in the recording process using the October transactions of Sierra Corporation. Sierra’s accounting period is a month. A basic analysis and a debit–credit analysis precede the journalizing and posting of each transaction. Study these transaction analyses carefully.

• The purpose of transaction analysis is first to identify the type of account involved and then to determine whether a debit or a credit to the account is required.
• You should always perform this type of analysis before preparing a journal entry. Doing so will help you understand the journal entries discussed in this chapter as well as more complex journal entries to be described in later chapters.

Summary Illustration of Journalizing and Posting

The journal for Sierra Corporation for the month of October is summarized in Illustration 3.33. The ledger is shown in Illustration 3.34 with all balances highlighted in red.

Limitations of a Trial Balance

A trial balance does not prove that all transactions have been recorded or that the ledger is correct. Numerous errors may exist even though the trial balance column totals agree (see Ethics Note). For example, the trial balance may balance even when any of the following occurs:

1. A transaction is not journalized.
2. A correct journal entry is not posted.
3. A journal entry is posted twice.
4. Incorrect accounts are used in journalizing or posting.
5. Offsetting errors are made in recording the amount of a transaction.

In other words, as long as equal debits and credits are posted, even to the wrong account or in the wrong amount, the total debits will equal the total credits. Nevertheless, despite these limitations, the trial balance is a useful screen for finding errors and is frequently used in practice.

Learning Objectives Review

Each business transaction must have a dual effect on the accounting equation. For example, if an individual asset is increased, there must be a corresponding (a) decrease in another asset, or (b) increase in a specific liability, or (c) increase in stockholders’ equity.

An account is an individual accounting record of increases and decreases in specific asset, liability, and stockholders’ equity, revenue, or expense items.

The terms debit and credit are synonymous with left and right. Assets, dividends, and expenses are increased by debits and decreased by credits. Liabilities, common stock, retained earnings, and revenues are increased by credits and decreased by debits.

The basic steps in the recording process are (a) analyze each transaction in terms of its effect on the accounts, (b) enter the transaction information in a journal, and (c) transfer the journal information to the appropriate accounts in the ledger.

The initial accounting record of a transaction is entered in a journal before the data are entered in the accounts. A journal (a) discloses in one place the complete effect of a transaction, (b) provides a chronological record of transactions, and (c) prevents or locates errors because the debit and credit amounts for each entry can be readily compared.

The entire group of accounts maintained by a company is referred to collectively as a ledger. The ledger provides the balance in each of the accounts as well as keeps track of changes in these balances.

Posting is the procedure of transferring journal entries to the ledger accounts. This phase of the recording process accumulates the effects of journalized transactions in the individual accounts.

A trial balance is a list of accounts and their balances at a given time. The primary purpose of the trial balance is to prove the mathematical equality of debits and credits after posting. A trial balance also uncovers errors in journalizing and posting and is useful in preparing financial statements.

Decision Tools Review

Glossary Review

Account

An individual accounting record of increases and decreases in specific asset, liability, stockholders’ equity, revenue, or expense items.

Accounting information system

The system of collecting and processing transaction data and communicating financial information to decision-makers.

Accounting transactions

Events that require recording in the financial statements because they affect assets, liabilities, or stockholders’ equity.

Chart of accounts

A list of the names of a company’s accounts.

Credit

The right side of an account.

Debit

The left side of an account.

Double-entry system

A system that records the two-sided effect of each transaction in appropriate accounts.

General journal

The most basic form of journal.

General ledger

A ledger that contains all asset, liability, stockholders’ equity, revenue, and expense accounts.

Journal

An accounting record in which transactions are initially recorded in chronological order.

Journalizing

The procedure of entering transaction data in the journal.

Ledger

A record of all accounts maintained by a company and their amounts.

Posting

The procedure of transferring journal entry amounts to the ledger accounts.

T-account

The basic form of an account.

Trial balance

A list of accounts and their balances at a given time.

Practice Multiple-Choice Questions

Practice Brief Exercises

Practice Exercises

Questions

1. Describe the accounting information system.

2. Can a business enter into a transaction that affects only the left side of the basic accounting equation? If so, give an example.

3. Are the following events recorded in the accounting records? Explain your answer in each case.

1. A major stockholder of the company dies.
2. Supplies are purchased on account.
3. An employee is fired.
4. The company pays a cash dividend to its stockholders.

4. Indicate how each business transaction affects the basic accounting equation.

1. Paid cash for janitorial services.
2. Purchased equipment for cash.
3. Issued common stock to investors in exchange for cash.
4. Paid an account payable in full.

5. Why is an account referred to as a T-account?

6. The terms debit and credit mean “increase” and “decrease,” respectively. Do you agree? Explain.

7. Barry Barack, a fellow student, contends that the double-entry system means each transaction must be recorded twice. Is Barry correct? Explain.

8. Misty Reno, a beginning accounting student, believes debit balances are favorable and credit balances are unfavorable. Is Misty correct? Discuss.

9. State the rules of debit and credit as applied to (a) asset accounts, (b) liability accounts, and (c) the Common Stock account.

10. What is the normal balance for each of these accounts?

1. Accounts Receivable.
2. Cash.
3. Dividends.
4. Accounts Payable.
5. Service Revenue.
6. Salaries and Wages Expense.
7. Common Stock.

11. Indicate whether each account is an asset, a liability, or a stockholders’ equity account, and whether it would have a normal debit or credit balance.

1. Accounts Receivable.
2. Accounts Payable.
3. Equipment.
4. Dividends.
5. Supplies.

12. For the following transactions, indicate the account debited and the account credited.

1. Supplies are purchased on account.
2. Cash is received on signing a note payable.
3. Employees are paid salaries in cash.

13. For each account listed here, indicate whether it generally will have debit entries only, credit entries only, or both debit and credit entries.

1. Cash.
2. Accounts Receivable.
3. Dividends.
4. Accounts Payable.
5. Salaries and Wages Expense.
6. Service Revenue.

14. What are the normal balances for the following accounts of Apple? (a) Accounts Receivable, (b) Accounts Payable, (c) Sales, and (d) Selling, General, and Administrative Expenses.

15. What are the basic steps in the recording process?

16.

1. When entering a transaction in the journal, should the debit or credit be written first?
2. Which should be indented, the debit or the credit?

17.

1. Should accounting transaction debits and credits be recorded directly in the ledger accounts?
2. What are the advantages of first recording transactions in the journal and then posting to the ledger?

18. Journalize these accounting transactions.

1. Stockholders invested $12,000 in the business in exchange for common stock.
2. Insurance of $800 is paid for the year.
3. Supplies of $1,800 are purchased on account.
4. Cash of $7,500 is received for services rendered.

19.

1. What is a ledger?
2. Why is a chart of accounts important?

20. What is a trial balance and what are its purposes?

21. Brad Tyler is confused about how accounting information flows through the accounting system. He believes information flows in this order:

1. Debits and credits are posted to the ledger.
2. Accounting transaction occurs.
3. Information is entered in the journal.
4. Adjusting entries are entered, adjusted trial balance is prepared, and financial statements are prepared.
5. Trial balance is prepared.

Indicate to Brad the proper flow of the information.

22. Two students are discussing the use of a trial balance. They wonder whether the following errors, each considered separately, would prevent the trial balance from balancing. What would you tell them?

1. The bookkeeper debited Cash for $600 and credited Salaries and Wages Expense for $600 for payment of wages.
2. Cash collected on account was debited to Cash for $800, and Service Revenue was credited for $80.

Brief Exercises

DO IT! Exercises

Exercises

Problems

Continuing Case

Cookie Creations

(Note: This is a continuation of the Cookie Creations from Chapters 1 and 2.)

CCC3 In November 2023, after having incorporated Cookie Creations Inc., Natalie begins operations. She has decided not to pursue the offer to supply cookies to Biscuits. Instead, she will focus on offering cooking classes. The following events occur.

Nov.8	Natalie cashes in her U.S. Savings Bonds and receives $520, which she deposits in her personal bank account.
8	Natalie opens a bank account for Cookie Creations Inc.
8	Natalie purchases $500 of Cookie Creations’ common stock.
11	Cookie Creations purchases paper and other office supplies for $95. (Use Supplies.)
14	Cookie Creations pays $125 to purchase baking supplies, such as flour, sugar, butter, and chocolate chips. (Use Supplies.)
15	Natalie starts to gather some baking equipment to take with her when teaching the cookie classes. She has an excellent top-of-the-line food processor and mixer that originally cost her $550. Natalie decides to start using it only in her new business. She estimates that the equipment is currently worth $300, and she transfers the equipment into the business in exchange for additional common stock.
16	The company needs more cash to sustain its operations. Natalie’s grandmother lends the company $2,000 cash, in exchange for a two-year, 9% note payable. Interest and the principal are repayable at maturity.
17	Cookie Creations pays $900 for additional baking equipment.
18	Natalie schedules her first class for November 29. She will receive $100 on the date of the class.
25	Natalie books a second class for December 5 for $150. She receives a $60 cash down payment, in advance.
29	Natalie teaches her first class, booked on November 18, and collects the $100 cash.
30	Natalie’s brother develops a website for Cookie Creations Inc. that the company will use for advertising. He charges the company $600 for his work, payable at the end of December. (Because the website is expected to have a useful life of two years before upgrades are needed, it should be treated as an asset called Website.)
30	Cookie Creations pays $1,200 for a one-year insurance policy.
30	Natalie teaches a group of elementary school students how to make Santa Claus cookies. At the end of the class, Natalie leaves an invoice for $300 with the school principal. The principal says that he will pass it along to the business office and it will be paid some time in December.
30	Natalie receives a $50 invoice for use of her cell phone. She uses the cell phone exclusively for Cookie Creations Inc. business. The invoice is for services provided in November, and payment is due on December 15.

Instructions

1. Prepare journal entries to record the November transactions.
2. Post the journal entries to the general ledger accounts.
3. Prepare a trial balance at November 30, 2023.

Expand Your Critical Thinking

A Look at IFRS