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chapter 2

The Accounting System

Learning Goals

• 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 2Section 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

Exhibit 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

Large and successful businesses have invariably developed robust accounting informa-tion systems. This suggests that the pathway to business success entails more than just product development and marketing. It also entails thoughtful development of well- designed 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 busi- ness 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 2Section 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” manipu- lation 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 well- trained 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 per- son 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 pre- served 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 intro- duces these important tools and helps you understand how they can be effectively used to capture and process information.

2.2 Accounts and Debits/Credits

An account is the master record that is maintained for each individual financial state-ment asset, liability, equity, revenue, expense, or dividend component. Every finan- cial 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 equa- tion, 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 2Section 2.2 Accounts and Debits/Credits

Beginning students are typically mystified about how this equality is consistently pre- served. There is an answer to this, and the answer’s brilliance helps explain how the fun- damental 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 account- ing 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 skep- tical? 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 busi- nesspeople 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 2Section 2.2 Accounts and Debits/Credits

Exhibit 2.1: Assets, expenses, and dividend accounts

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

Normal Balance Is Debit

Decreased With Credits

Increased With Debits

Assets Expenses Dividends

Normal Balance Is Credit

Decreased With Debits

Increased With Credits

Liabilities Revenues

Equity

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CHAPTER 2Section 2.2 Accounts and Debits/Credits

Table 2.1: Schedule of debit and credit rules for typical accounts

Normal Balance Increased With Decreased With

Typical Assets

Cash

Accounts Receivable

Inventory Debit Debit Credit

Land

Buildings

Equipment

Typical Liabilities

Accounts Payable

Salaries Payable Credit Credit Debit

Notes and Loans Payable

Typical Equities

Capital Stock Credit Credit Debit

Retained Earnings

Typical Revenues

Service Revenue Credit Credit Debit

Sales

Typical Expenses

Salaries and Wages

Utilities

Interest Debit Debit Credit

Rent

Supplies

Taxes

Dividends

Dividends Debit Debit Credit

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 2Section 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 demon- strate 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 show- ing 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

The process of maintaining accountability over a business’s affairs begins with an anal-ysis 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 2Section 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 con- sequence, 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 combina- tion 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 2Section 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 trans- action 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 window- washing 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 both increased by the same amount.

Cash, an asset, is increased with 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 account is increased by the same amount (which causes a decrease in Retained Earnings/Equity).

Dividends are increased with a debit 5 Cash, an asset, is decreased with a credit

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CHAPTER 2Section 2.3 Transaction Analysis

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: Spreadsheet for Clearview Window Washers for December

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CHAPTER 2Section 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

You 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 busi- ness, the general journal is a log of the transactions engaged in by the business. How- ever, 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 cor- respond 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 2Section 2.4 General Journal

Exhibit 2.6: Example journal entries for Clearview Window Washers

Date Accounts Debit Credit

10,000

30,000

20,000

3,000

2,500

6,000

12,000

75,000

10,000

30,000

20,000

3,000

2,500

6,000

12,000

20,000

General Journal Page 1

Cash

Provided services for cash

Dec. 20X5

Revenues

Accounts Receivable

Provided services on account

Revenues

Cash

Collected outstanding receivable

Accounts Receivable

Supplies Expense

Used supplies from existing inventory

Supplies

Purchased supplies on account

Accounts Payable

Paid outstanding account payable

Cash

Issued capital stock for cash

Capital Stock

Wages Expense

Issued capital stock for cash

Cash

Dividends

Paid dividends to shareholders

Cash

Land

Purchased land for cash and loan

Cash

Loan Payable

Dec. 20X5

7,000

5,000

55,000

7,000

5,000

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CHAPTER 2Section 2.5 Chart of Accounts

2.5 Chart of Accounts

You 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 usu- ally 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 jour- nal’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 2Section 2.5 Chart of Accounts

Exhibit 2.7: Sample page from the general ledger for the Cash account

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 deter- mine the balance for each account. Exhibit 2.8 shows a comprehensive illustration for Clearview’s general journal and ledger for December.

Date Description Debit Credit Balance

$ 10,000

20,000

12,000

$ 50,000

60,000

80,000

74,000

86,000

66,000

59,000

54,000

$ 6,000

20,000

7,000

5,000

Account: Cash

Balance forward

Provided services for cash

Collected receivable

Paid outstanding accounts payable

Issued capital stock

Purchased land

Paid wages

Paid dividends

Dec. 20X5

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CHAPTER 2Section 2.5 Chart of Accounts

Exhibit 2:8: Clearview Window Washing’s general journal and ledger

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waL80144_02_c02_027-052.indd 15 8/29/12 2:43 PM

CHAPTER 2Section 2.5 Chart of Accounts

A properly designed system of journals and ledgers will usually include a numeric cross- referencing 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 transac- tion or even to post the same transaction twice. Computerized posting somewhat elimi- nates 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 list- ing 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: Trial balance sheet for Clearview Window Washers

Review of the Sequence of Transaction Recording

To review, notice that the accounting sequence has entailed (1) analyzing each transac- tion 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.

Debits Credits

$ 4,500

57,000

$ 62,000

140,000

40,000

–

$ 303,500

Cash

Accounts receivable

Supplies

Land

Accounts payable

Loans payable

Capital stock

Retained earnings (beginning)

Dividends

Revenue

Supplies expense

Wages expense

$ 54,000

135,000

4,500

95,000

$ 5,000

3,000

7,000

$ 303,500

Clearview Window Washers Trial Balance

December 31, 20X5

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CHAPTER 2Section 2.5 Chart of Accounts

Dismiss the thought. What has been described is really just the beginning of the account- ing 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 transac- tions 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 trig- gering 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 follow- ing 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 trans- action 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. Numer- ous 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 state- ment 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, pay- roll, 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 spe- cially designed journal can be helpful when billing customers. Additionally, special jour- nals can reduce the amount of processing and posting that is necessary within a manual

waL80144_02_c02_027-052.indd 17 8/29/12 2:43 PM

CHAPTER 2Section 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 spe- cial journals (but not replaced).

2.6 Source Documents

Acompany 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 informa- tion 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

Throughout this chapter, a number of references have been made to computerized accounting. Most accounting software has a number of features in common. For start- ers, 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 fre- quency identification chips, and that tracking process can link into the company account- ing 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 busi- ness. 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 impor- tant control feature.

waL80144_02_c02_027-052.indd 18 8/29/12 2:43 PM

CHAPTER 2Section 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

2.8 Critical Thinking About Debits and Credits

Earlier 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.

502 Utilities Expense $1,000.00

Debits Credits

201 Accounts Payable $1,000.00

$1,000.00 $1,000.00

+ » $ √ ∞ ×

Actions List: Create an Invoice Receive a Payment Record an Expense View Statements Manage Accounts Generate a Report

File Edit View Help

Entry in balance

Record entry #756

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CHAPTER 2Concept 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

Key Terms

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?

account The master record that is main- tained for each individual financial state- ment asset, liability, equity, revenue, expense, or dividend component.

bookkeeping The skill or process of recording of transactions.

chart of accounts A numbering system in which a unique number is assigned to each account.

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.

general journal A log of the transactions engaged in by the business.

general ledger The collection of all accounts.

posting The process of transferring data from the journal into the general ledger.

source document Tangible evidence of the existence and nature of a transaction.

special journal A subdivision of a general journal.

T-account A device that is used to dem- onstrate the impact of certain transactions and events.

trial balance A listing of accounts and their respective balances.

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CHAPTER 2Exercises

Exercises

1. Recognition 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. General journal and general ledger content. St. James Services uses a general jour- nal and general ledger to process transactions. Assume that the volume of trans- actions 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. Basic 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.

waL80144_02_c02_027-052.indd 22 8/29/12 2:43 PM

CHAPTER 2Problems

Prepare journal entries (and explanations) to record the preceding transactions and events.

4. Trial balance preparation. Brighton Company began operation on March 1 of the current year. The following account balances were extracted from the general led- ger on March 31; all accounts have normal balances.

Accounts Payable $ 12,000 Interest Expense $ 300 Accounts Receivable 8,800 Land ? Advertising Expense 5,700 Loan Payable 26,000 Bob Brighton, Capital 30,000 Salaries Expense 11,100 Cash 22,500 Utilities Expense 700 Fees Earned 18,900

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. Trial 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. Transaction 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

waL80144_02_c02_027-052.indd 23 8/29/12 2:43 PM

CHAPTER 2Problems

Accounts Receivable Computer Equipment (c) 14,000 (f) 8,000 (b) 26,000

(e) 9,000 (g) 7,000

Accounts Payable Loan Payable Miller, Capital (g) 7,000 (j) 800

(e) 9,000 (h) 1,500 (a) 35,000 (b) 36,000

Fees Earned Advertising Expense Utilities Expense

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. Entry 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 Cash $ 2,700 120 Accounts Receivable 12,100 130 Equipment and Supplies 2,800 140 Studio 45,000 210 Accounts Payable $ 2,600 310 Lee Adkins, Capital 57,400 320 Lee Adkins, Drawing 30,000 410 Professional Fees 39,000 510 Advertising Expense 2,300 520 Salaries Expense 2,100 540 Utilities Expense 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: Received a $500 bill from the accountant for preparing last quarter ’s 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.

waL80144_02_c02_027-052.indd 24 8/29/12 2:43 PM

CHAPTER 2Problems

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 num- bers, and May 31 balances.

c. Post the journal entries to the ledger. d. Prepare a trial balance as of June 30.

3. Journal entry preparation. On January 1 of the current year, MuniServ began operations with $100,000 cash. The cash was obtained from an owner (Peter Hous- ton) 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 500

Salaries expense 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?

waL80144_02_c02_027-052.indd 25 8/29/12 2:43 PM

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