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  • Chapter 3: The Accounting Cycle—Capturing Economic Events. <br />
  • All accountants play a pivotal roll in establishing and maintaining economic information about a company. Much of Chapter Three will illustrate how an accounting system works. Most information is stored on computers -- and accounting information is no exception. <br /> Accountants must be proficient in establishing and maintaining databases of financial information for a company. This information is used to prepare financial statements and other reports of interest to management and others. <br />
  • An account is an individual record showing increases and decreases in the balance. Think of a checkbook as an account. In it, cash receipts and disbursements are maintained, in chronological order, as well as the current account balance. <br /> The entire group of accounts for a particular business is called the ledger. <br />
  • Accountants often use a T account to represent a general ledger account. It is a quick way to analyze transactions before entering information in the journal. The left side of a T account is always called the debit side, and the right side is always called the credit side. This terminology comes from the time when the double-entry system was first developed. These terms are still used as a matter of convention. The words do not have any significant meaning other than they stand for the left and right side of a ledger account. Increases and decreases in an account balance are handled differently, depending upon the nature of the account. <br />
  • Part IHere are the dates and amounts of transactions that impacted the cash account of JJ’s Lawn Service for the month of May.Part IIBecause cash is an asset, all receipts, or increases, should be placed on the debit, or left, side of the ledger account. <br /> Part IIIIf increases are placed on the left side of the account, all payments, or decreases, should be placed on the right, or credit, side of the account, according to the basic accounting rules for assets. <br /> Part IVThe balance in any account is the difference between total debits and credits. The balance is placed on the side with the greater dollar amount. <br />
  • To review, the left side of a ledger account is always called the debit, and the right side is always called the credit. Now, let’s move on to the mathematics of the double-entry system. Liabilities and equity have the opposite sign of assets. If liabilities were to move to the left side of the equation, it would read assets minus liabilities equal equity. As a convention of double-entry accounting, it’s been decided that a debit, or left side, of an asset account will represent an increase in the asset account balance. This convention determines all of the remaining math.Because liabilities and equity have the opposite sign of assets, a debit to a liability or equity account must mean a decrease and a credit means an increase. Instead of using the terms increase and decrease we use the terms debit and credit. It is important to remember whether we are talking about an asset, liability, or equity account for the meaning of a debit or a credit. <br /> It may take a short while to become accustomed to using the terms debit and credit, but with practice the concept can be easily mastered. <br />
  • Accountants use the double-entry accounting system. This means that all transactions will have an equal dollar amount of debits and credits. <br />
  • Let’s revisit many of the transactions of JJ’s Lawn Care, placing the amount of each transaction in the proper ledger account. Try to determine how the amounts will be posted before moving on to see the answer. <br />
  • Part IRemember the transaction on May 1st when Jill Jones and her family invested $8,000 in JJ’s Lawn Care and received 800 shares of capital stock? Did the cash account increase or decrease? How about the capital stock account; did it increase or decrease? <br /> Part II <br /> The Cash account increased, so $8,000 was placed on the left, or debit, side of the ledger account. Remember, a debit to an asset account means an increase.The capital stock account was increased, or credited, for $8,000. Remember, a credit to an equity account represents an increase in the account. <br /> This results in an equal debit and credit impact in this transaction, so we have followed the rules of double-entry accounting. <br />
  • Part IHere is the transaction where JJ’s Lawn Care purchased the riding lawn mower for cash. Will the cash account increase or decrease? Will the tools and equipment account increase or decrease? This decision must be made before we can determine which side of the ledger account will be used to record the amount involved. <br /> Part II <br /> The cash account will decrease by $2,500. A decrease in an asset account is shown with a credit. This amount is put on the credit, or right, side of the ledger account. <br /> The asset account tools and equipment increased. An increase is shown in an asset account with a debit. The $2,500 is put on the debit, or left, side of the ledger account. <br />
  • Part IJJ’s Lawn Care purchases a truck, paying $2,000 cash and signing a note for the balance of $13,000. Will the truck account increase or decrease? How about the cash and notes payable accounts; will they increase or decrease? <br /> Part II <br /> The truck account is an asset. An increases in an asset accounts is shown with a debit. The cost of the truck, $15,000, is placed on the debit, or left, side of the ledger account.The cash account will decrease by $2,000. A decrease in an asset account is shown with a credit. The payment is placed on the credit, or right, side of the cash ledger account.The notes payable account is a liability. The account balance increased. An increase in a liability account is shown with a credit. So, the $13,000 is placed on the credit, or right, side of the notes payable ledger account. <br />
  • Part IJJ’s Lawn Care purchased repair parts for the riding lawn mower in the amount of $300. The company promised to pay the amount to the supplier at some point in the future. Will the tools and equipment account increase or decrease? Will the accounts payable account increase or decrease? Remember to determine the nature of the account involved when deciding increases or decreases. This decision will help place the amount on the correct side of the ledger accounts involved. <br /> Part II <br /> The asset account, tools and equipment, increased. Increases in asset accounts are shown on the debit, or left, side of the ledger account. So, $300 is placed on the debit side of the tools and equipment account.Accounts payable, a liability account, increased by $300. Increases in liability accounts are shown as credits. So, the amount involved is placed on the credit, or right, side of the accounts payable ledger account. <br />
  • Part IRecall that JJ’s Lawn Care sold one-half of its repair parts for their original cost, or $150, to ABC Lawns. ABC Lawns agrees to pay the amount due in thirty days. Will the tools and equipment account increase or decrease? Will the accounts receivable account increase or decrease? <br /> Part II <br /> The asset account, tools and equipment, decreased by $150. Decreases in asset accounts are shown with a credit. So, the amount is placed on the credit, or right, side of the asset account, tools and equipment.The asset account, accounts receivable, increased by $150. Increases in asset accounts are shown as debits. So, the amount is placed on the debit, or left, side of the asset account, accounts receivable. <br />
  • Transactions are initially recorded in the journal rather than the ledger account. The journal records transactions in chronological order. The ledger groups together all transactions that impact a particular account.When preparing a journal entry, always list debit accounts and amounts first and show credit accounts and amounts below the debits, indented slightly.Proper form requires that each journal entry be followed by a short description of the transaction. We skip a line after the description of the transaction before we start our next journal entry. <br />
  • At the end of the accounting period, transactions are posted from the journal into the ledger account. Posting is the process of systematically copying information from the journal to the ledger. Care must be taken when doing so, as it is easy to make mistakes. <br />
  • Part I <br /> A journal entry is shown here. Let’s see how to post this information from the journal to the ledger.Part IIFirst, find the proper ledger account. In this case, the cash ledger account.Part IINext, copy the date to the ledger account.Part IVFinally, copy the amount from the debit column in the journal to the debit column in the ledger. Update the balance in the cash account. The current balance is eight thousand dollars.Now, let’s post the credit side of the journal entry. <br />
  • Part IFirst, locate the capital stock account in the general ledger.Part IINext, copy the date from the journal entry to the proper column in the capital stock account.Part IIFinally, copy the amount from the credit column in the journal to the credit column in the ledger. Update the account balance for the new posting. <br />
  • The journal entry to record the purchase of the riding lawn mower is shown here. What will the cash ledger account look like after posting the cash portion of this journal entry? <br />
  • The posting was properly placed in the credit, or decrease, column of the cash ledger account. The balance in the account is updated and is currently $5,500. <br />
  • In accounting, a T account is frequently used to represent a ledger account. You can see the red lines that show how we get the term T account. The T account is a simple way to debit or credit a ledger account for illustration purposes. T accounts are not part of the accounting system. <br />
  • Part INet income, the excess of revenues earned over expenses incurred, is not an asset. Net income increases owners’ equity by increasing retained earnings.Part IIWhen a company earns income, assets must increase or liabilities must decrease to reflect the earnings process. Remember, when JJ’s Lawn Care rendered services to its customers the asset account, cash, increased and so did the owners’ equity account, retained earnings.Part IIINet income always represents an increase in the owners’ equity of a company. <br />
  • Owners’ equity is comprised of capital stock and retained earnings. The retained earnings account represents all the accumulated earnings of the company since inception that have not been paid to owners. <br />
  • Here is the income statement of JJ’s Lawn Care we prepared in the previous chapter. Remember, the income statement is prepared for a period of time. In this case, it’s for the month ended May 31, 2009. <br />
  • To provide timely and meaningful information to users of financial statements, business operations are divided into arbitrary time periods. Financial statements are usually prepared monthly. However, many transactions cross from one accounting period to the next. This creates a problem for accountants. <br />
  • Part IRevenues represent the price of goods sold or services rendered to customers during any given accounting period. Revenues increase owners’ equity.Part IIExpenses are the cost of goods or services used up in the process of earning revenue. Accountants try to match expenses incurred with the revenues generated in an accounting period. Expenses decrease owners’ equity. <br />
  • One of the basic concepts of accounting is that revenue should be recognized when the goods or services are sold to customers. This concept may take some time to understand, as most people are cash-based. That is, they recognize revenue when cash is received rather than when it is earned and recognize expenses when paid rather than when incurred. <br />
  • The matching principle states that we must match expenses with the period in which they are used. <br />
  • The policy of recognizing revenue in the accounting records when it is earned and recognizing expenses when the related goods or services are used is called the accrual basis of accounting. The purpose of accrual accounting is to measure the profitability of the economic activities conducted during the accounting period. Revenue is offset with all of the expenses incurred in generating that revenue, thus providing a measure of the overall profitability of the economic activity. <br />
  • Part ILet’s look more closely at the recording of revenues and expenses. To review, revenues increase owners’ equity and expenses decrease owners’ equity.Part IIA decrease is shown in owners’ equity with a debit. Increases in expenses must be recorded as debits in a separate ledger account.Part IIIAn increase in owners’ equity is shown with a credit. Increases in revenues must be recorded as credits in a separate ledger account. <br />
  • Part ITo review, payments to owners decrease owners’ equity and investments by owners increase owners’ equity.Part IIDividends represent payments to owners of a corporation. An increase in the dividend account must be shown with a debit.Part IICapital stock represents investments by owners of a corporation. An increase in the capital stock account must be shown with a credit. <br />
  • Let’s look at recording revenues, expenses, and payments to owners of JJ’s Lawn Care. <br />
  • Part ILet’s reanalyze the transaction where JJ’s Lawn Care provided services to customers and received $750 cash. Will the cash ledger account increase or decrease? Will the sales revenue ledger account increase or decrease? <br /> Part II <br /> The asset account, cash, increased by $750. An increase is shown in an asset account on the debit, or left, side of the account.The revenue account, sales revenue, increased by $750. An increase in a revenue account is shown with a credit. So, the amount is placed on the credit, or right, side of the account. <br />
  • Part I <br /> Remember the transactions where JJ’s Lawn Care purchased gasoline for the riding mower and truck, paying $50 cash? Will the cash account increase or decrease? Will the gasoline expense account increase or decrease? This is the first transaction to include a separate expense account. <br /> Part II <br /> The asset account, cash, will decrease by $50. So, the decrease will show on the credit, or right, side of the cash account.The gasoline expense account increased by $50. Increases in expense accounts are shown as debits. The $50 increase in gasoline expense is shown on the debit, or left, side of the ledger account. <br />
  • Part I <br /> Here is a new transaction. On May 31st, JJ’s Lawn Care paid a dividend to its owners in the amount of $200. Will the cash account increase or decrease? Will the dividend account increase or decrease? <br /> Part II <br /> The asset account, cash, decreased by $200. The decrease is shown on the credit, or left, side of the ledger account.The dividend account increased by $200. The increase is shown in the dividend account with a debit for $200. Remember, dividends reduce total owners’ equity. <br />
  • Let’s take a first look at a trial balance. On the next slides is the May 31st, trial balance of JJ’s Lawn Care. <br />
  • Part I <br /> A trial balance lists the balances of all accounts in the ledger. Remember that all transactions have an equal debit and credit impact. The total debit balance should be equal to the total credit balance according to the rules of double-entry bookkeeping. <br /> Part II <br /> The total of the debit balance accounts is $21,900. This is exactly equal to the total of the credit balance accounts. So, the books are in balance. <br />
  • We view the accounting cycle as an efficient means of introducing basic accounting terms, concepts, processes, and reports. Please do not confuse your familiarity with this sequence of procedures with a knowledge of accounting. The accounting cycle is but one accounting process—and a relatively simple one at that. Accountants spend much of their time focusing on the more analytical aspects of their discipline. These include, for example: <br /> Determining the information needs of decision makers. <br /> Designing systems to provide the information quickly and efficiently. <br /> Evaluating the efficiency of operations throughout the organization. <br /> Assisting decision makers in interpreting accounting information. <br /> Auditing, which is confirming the reliability of accounting information. <br /> Forecasting the probable results of future operations. And, <br /> Tax planning. <br />
  • End of chapter 3. <br />

Transcript

  • 1. The Accounting Cycle: Capturing Economic Events Chapter 3 McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
  • 2. The Role of Accounting Records Establishes accountability for assets Establishes accountability for assets and transactions. and transactions. Keeps track of routine business Keeps track of routine business activities. activities. Obtains detailed information about a Obtains detailed information about a particular transaction. particular transaction. Evaluates efficiency and Evaluates efficiency and performance within company. performance within company. Maintains evidence of a company’s Maintains evidence of a company’s business activities. business activities. 3-2
  • 3. The Ledger Cash Accounts Payable Capital Stock Accounts are Accounts are individual records individual records showing increases showing increases and decreases. and decreases. The entire group of The entire group of accounts is kept accounts is kept together in an together in an accounting record accounting record called a ledger. called a ledger. 3-3
  • 4. The Use of Accounts Increases are recorded on one side of the T account, and decreases are recorded on the other side. Title of Account Left or Debit Side Right or Credit Side 3-4
  • 5. Debit and Credit Entries Receipts are on the debit side. 5/1 5/25 5/29 5/31 Bal. Cash 8,000 5/2 2,500 Payments are 75 5/8 2,000 on the credit side. 750 5/28 150 5/31 50 4,125 The balance is the The balance is the difference between the difference between the debit and credit entries debit and credit entries in the account. in the account. 3-5
  • 6. Debit and Credit Entries Debits and credits affect accounts as follows: A = L + OE ASSETS LIABILITIES EQUITIES Debit Credit for for Increase Decrease Debit Credit for for Decrease Increase Debit Credit for for Decrease Increase 3-6
  • 7. Double Entry Accounting  The Equality of Debits and Credits A = L + OE = Debit balances Credit balances In the double-entry accounting system, In the double-entry accounting system, every transaction is recorded by equal every transaction is recorded by equal dollar amounts of debits and credits. dollar amounts of debits and credits. 3-7
  • 8. Let’s record selected transactions for JJ’s Lawn Care Service in the accounts. 3-8
  • 9.  May 1: Jill Jones and her family invested $8,000  May 1: Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and received 800 shares in JJ’s Lawn Care Service and received 800 shares of stock. of stock. Will Cash increase Cash increases $8,000 with a debit. or decrease? Cash 5/1 8,000 Will Capital Stock Capital Stock increases $8,000 increase or with a credit. decrease? Capital Stock 5/1 8,000 3-9
  • 10.  May 2: JJ’s purchased a riding lawn mower  May 2: JJ’s purchased a riding lawn mower for $2,500 cash. for $2,500 cash. Will Cash increase Cash decreases $2,500decrease? or with a credit. Cash 5/1 8,000 5/2 2,500 Tools & Tools & Will Equipment Equipment increase increases $2,500 or decrease? with a debit. Tools & Equipment 5/2 2,500 3-10
  • 11.  May 8: JJ’s purchased a $15,000 truck. JJ’s paid  May 8: JJ’s purchased a $15,000 truck. JJ’s paid $2,000 in cash and issued a note payable for the $2,000 in cash and issued a note payable for the remaining $13,000. remaining $13,000. Truck increases Will Truck increase $15,000 with a debit. or decrease? Truck 5/8 15,000 Will Cash and Notes Payable increase or decrease? Cash 5/1 8,000 5/2 2,500 5/8 2,000 Notes Payable 5/8 13,000 3-11
  • 12.  May 11: JJ’s purchased some repair parts  May 11: JJ’s purchased some repair parts for $300 on account. for $300 on account. Tools & Tools & Will Equipment Equipment increase increases $300 with or decrease? a debit. Will Accounts Payable increase or decrease? Tools & Equipment 5/2 2,500 5/11 300 Accounts Payable 5/11 300 3-12
  • 13.  May 18: JJ’s sold half of the repair parts to  May 18: JJ’s sold half of the repair parts to ABC Lawns for $150, a price equal to JJ’s cost. ABC Lawns for $150, a price equal to JJ’s cost. ABC Lawns agrees to pay JJ’s within 30 days. ABC Lawns agrees to pay JJ’s within 30 days. Tools & Tools & Will Equipment decreases $150 with Equipment increase or a credit. decrease? Tools & Equipment 5/2 2,500 5/18 150 5/11 300 Will Accounts Receivable increase or decrease? Accounts Receivable 5/18 150 3-13
  • 14. The Journal In an actual accounting system, In an actual accounting system, transactions are initially recorded in the transactions are initially recorded in the journal. journal. GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit 2009 May 1 Cash Capital Stock 8,000 8,000 Owners invest cash in the business. 3-14
  • 15. Posting Journal Entries to the Ledger Accounts Posting simply means updating the ledger accounts for the effects of the transactions recorded in the journal. 3-15
  • 16. Posting Journal Entries to the Ledger Accounts GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit 2009 May 1 Cash 8,000 Capital Stock 8,000 Owners invest cash in the business. General Ledger Date 2009 May 1 Cash Debit Credit 8,000 Balance 8,000 3-16
  • 17. Posting Journal Entries to the Ledger Accounts GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit 2009 May 1 Cash 8,000 Capital Stock 8,000 Owners invest cash in the business. General Ledger Date 2009 May 1 Capital Stock Debit Credit 8,000 Balance 8,000 3-17
  • 18. Posting Journal Entries to the Ledger Accounts GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit 2009 May 2 Tools & Equipment Cash 2,500 2,500 Purchased lawn mower. Let’s see what the cash account looks like Let’s see what the cash account looks like after posting the cash portion of this after posting the cash portion of this transaction for JJ’s Lawn Care Service. transaction for JJ’s Lawn Care Service. 3-18
  • 19. Ledger Accounts After Posting Date 2009 May 1 2 General Ledger Cash Debit Credit 8,000 2,500 Balance 8,000 5,500 This ledger format is referred to as a running balance. 3-19
  • 20. Ledger Accounts After Posting Date 2009 May 1 2 General Ledger Cash Debit Credit 8,000 2,500 Balance 8,000 5,500 T accounts are simplified versions of T accounts are simplified versions of the ledger account that only show the the ledger account that only show the debit and credit columns. debit and credit columns. 3-20
  • 21. What is Net Income? Net income is not an asset  it’s an increase Net income is not an asset  it’s an increase in owners’ equity from profits of the in owners’ equity from profits of the business. business. A = L + OE Increase Decrease As income is earned, either an asset is increased or a liability is decreased. Increase Net income always results in the increase of Owners’ Equity 3-21
  • 22. Retained Earnings A = L + OE Capital Stock Retained Earnings The balance in the Retained Earnings account represents the total net income of the corporation over the entire lifetime of the business, less all amounts which have been distributed to the stockholders as dividends. 3-22
  • 23. The Income Statement: A Preview JJ's Lawn Care Service Income Statement For the Month Ended May 31, 2009 Sales Revenue Operating Expense: Gasoline Expense Net Income $ 750 $ 50 700 The income statement summarizes the profitability The income statement summarizes the profitability of a business for a specified period of time. of a business for a specified period of time. 3-23
  • 24. Accounting Periods Time Period Principle To provide users of financial statements with timely information, net income is measured for relatively short accounting periods of equal length. 3-24
  • 25. Revenue and Expenses The price for goods sold and services rendered during a given accounting period. Increases owners’ equity. The costs of goods and services used up in the process of earning revenue. Decreases owner’s equity. 3-25
  • 26. The Matching Principle: When To Record Revenue Matching Principle Revenue should be recognized at the time goods are sold and services are rendered. 3-26
  • 27. The Matching Principle: When To Record Expenses Matching Principle Expenses should be recorded in the period in which they are used up. 3-27
  • 28. The Accrual Basis of Accounting Current Accounting Period Jan. 1, 2009 Jan. 1, 2009 Future Accounting Period Dec. 1, 2009 Dec. 1, 2009 Cash is received or paid Cash is received or paid here here Jan. 1, 2010 Jan. 1, 2010 But . . . Dec. 1, 2010 Dec. 1, 2010 The income statement The income statement reports revenue or reports revenue or expense here expense here OR The income statement The income statement reports revenue or reports revenue or expenses here expenses here But . . . Cash is received or paid Cash is received or paid here here 3-28
  • 29. Debit and Credit Rules for Revenue and Expenses Expenses decrease owners’ equity. EQUITIES Debit Credit for for Decrease Increase Revenues increase owners’ equity. EXPENSES REVENUES Debit Credit for for Increase Decrease Debit Credit for for Decrease Increase 3-29
  • 30. Dividends Payments to owners decrease owners’ equity. EQUITIES Debit Credit for for Decrease Increase DIVIDENDS Debit Credit for for Increase Decrease Owners’ investments increase owners’ equity. CAPITAL STOCK Debit Credit for for Decrease Increase 3-30
  • 31. Let’s analyze the Let’s analyze the revenue and revenue and expense expense transactions for transactions for JJ’s Lawn Care JJ’s Lawn Care Service for the Service for the month of May. month of May. We will also We will also analyze a dividend analyze a dividend transaction. transaction. 3-31
  • 32.  May 29: JJ’s provided lawn care services for  May 29: JJ’s provided lawn care services for a client and received $750 in cash. a client and received $750 in cash. Will Cash increase Cash increases $750 decrease? or with a debit. Cash 5/1 8,000 5/2 2,500 5/29 750 5/8 2,000 Will Sales Revenue increase or decrease? Sales Revenue 5/29 750 3-32
  • 33.  May 31: JJ’s purchased gasoline for the lawn  May 31: JJ’s purchased gasoline for the lawn mower and the truck for $50 cash. mower and the truck for $50 cash. CashCash increase Will decreases $50 or decrease? with a credit. Cash 5/1 8,000 5/2 2,500 5/29 750 5/8 2,000 5/31 50 Will Gasoline Expense increase or decrease? Gasoline Expense 5/31 50 3-33
  • 34.  May 31: JJ’s Lawn Care paid Jill Jones and  May 31: JJ’s Lawn Care paid Jill Jones and her family a $200 dividend. her family a $200 dividend. Will Dividends increase or decrease? Will Cash increase Cash decreases $200 decrease? or with a credit. Cash 5/1 8,000 5/2 2,500 5/29 750 5/8 2,000 5/31 50 5/31 200 5/31 Dividends 200 3-34
  • 35. Now, let’s look at Now, let’s look at the Trial Balance the Trial Balance for JJ’s Lawn for JJ’s Lawn Care Service for Care Service for the month of May. the month of May. 3-35
  • 36. JJ's Lawn Care Service Unadjusted Trial Balance May 31, 2009 Cash $ 3,925 Accounts receivable 75 Tools & equipment 2,650 Truck 15,000 Notes payable $ Accounts payable Capital stock Dividends 200 Sales revenue Gasoline expense 50 Total $ 21,900 $ 13,000 150 8,000 750 21,900 All balances are taken from the ledger accounts on May 31 after considering all of JJ’s transactions for the month. 3-36
  • 37. The Accounting Cycle in Perspective Accountants spend much of their time focusing on the more analytical aspects of their discipline. 3-37
  • 38. End of Chapter 3 3-38