CH. 3 OF FINANCIAL ACCOUNTING 2344

Resource: Ch. 3 of Financial Accounting
Complete Exercises E3-4 & E3-9.
Complete Problems 3-5A & 3-6A.
Submit as either a Microsoft® Excel® or Microsoft® Word document.

study objectives
After studying this chapter, you should be able to:
1 Analyze the effect of business transactions on the basic
accounting equation.
2 Explain what an account is and how it helps in the recording
process.
3 Define debits and credits and explain how they are used to
record business transactions.
4 Identify the basic steps in the recording process.
5 Explain what a journal is and how it helps in the recording
process.
6 Explain what a ledger is and how it helps in the recording
process.
7 Explain what posting is and how it helps in the recording
process.
8 Explain the purposes of a trial balance.
9 Classify cash activities as operating, investing, or
financing.
chapter
THE ACCOUNTING
INFORMATION SYSTEM
3
100
? Scan Study Objectives
? Read Feature Story
? Scan Preview
? Read Text and Answer
p. 110 p. 116 p. 119 p. 128
? Work Using the Decision Toolkit
? Review Summary of Study Objectives
? Work Comprehensive p. 133
? Answer Self-Test Questions
? Complete Assignments
? Go to WileyPLUS for practice and tutorials
? Read A Look at IFRS p. 159
? the navigator
Do it!
Do it!
?
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101
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?
• Is your wallet such a mess that it is often faster to
fish for money in the crack of your car
seat than to dig around in your wallet?
• Was Steve Nash playing high school
basketball the last time you balanced
your bank account?
• Have you ever been tempted to burn down your
house so you don’t have to try to find all of the receipts
and records that you need to fill out your tax
returns?
If you think it is hard to keep track of the many
transactions that make up your life, imagine what it is
like for a major corporation like Fidelity Investments.
Fidelity is one of the largest mutual fund management
firms in the world. If you had your life savings
invested at Fidelity Investments, you might be just
slightly displeased if, when you called to find out
your balance, the representative said, “You know, I
kind of remember someone with a name like yours
sending us some money—now what did we do with
that?”
To ensure the accuracy of your balance and the
security of your funds, Fidelity Investments, like all
other companies large and small, relies on a sophisticated
accounting information system. That’s not to say
that Fidelity or any other company is error-free. In fact,
if you’ve ever really messed up your
checkbook register, you may take some
comfort from one accountant’s mistake
at Fidelity Investments. The accountant
failed to include a minus sign while doing a calculation,
making what was actually a $1.3 billion loss look
like a $1.3 billion gain—yes, billion! Fortunately, like
most accounting errors, it was detected before any
real harm was done.
No one expects that kind of mistake at a company
like Fidelity, which has sophisticated computer systems
and top investment managers. In explaining the
mistake to shareholders, a spokesperson wrote,
“Some people have asked how, in this age of technology,
such a mistake could be made. While many of
our processes are computerized, accounting systems
are complex and dictate that some steps must be handled
manually by our managers and accountants, and
people can make mistakes.”
ACCI DENTS
HAP P E N
feature story
? Why Accuracy Matters (p. 109)
? Keeping Score (p. 115)
? Boosting Microsoft’s Profits (p. 119)
INSIDE CHAPTER 3 . . .
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The Accounting Information System
As indicated in the Feature Story, a reliable information system is a necessity for any company. The purpose of
this chapter is to explain and illustrate the features of an accounting information system. The organization and
content of the chapter are as follows.
The Accounting Information System
The system of collecting and processing transaction data and communicating financial
information to decision makers is known as the accounting information
system. Factors that shape these systems include: the nature of the company’s
business, the types of transactions, the size of the company, the volume
of data, and the information demands of management and others.
Most businesses use computerized accounting systems—sometimes referred
to as electronic data processing (EDP) systems. These systems handle all the
steps involved in the recording process, from initial data entry to preparation of
the financial statements. In order to remain competitive, companies continually
improve their accounting systems to provide accurate and timely data for decision
making. For example, in a recent annual report, Tootsie Roll states, “We
also invested in additional processing and data storage hardware during the year.
We view information technology as a key strategic tool, and are committed to
deploying leading edge technology in this area.” In addition, many companies
have upgraded their accounting information systems in response to the requirements
of Sarbanes-Oxley.
In this chapter, we focus on a manual accounting system because the accounting
concepts and principles do not change whether a system is computerized
or manual, and manual systems are easier to illustrate.
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 General Motors hired a new employee
or purchased a new computer. Are these 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. The purchase of a
preview of chapter 3
• Analyzing
transactions
• Summary of
transactions
Accounting
Transactions
• Debits and credits
• Debit and credit
procedures
• Stockholders’ equity
relationships
• Summary of
debit/credit rules
The Account
• The journal
• The ledger
• Chart of accounts
• Posting
Steps in the
Recording Process
• Summary illustration
of journalizing and
posting
The Recording
Process Illustrated
• Limitations of a trial
balance
The Trial Balance
102
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computer by General Motors, the payment of rent by Microsoft, and the sale of
a multi-day guided trip by Sierra Corporation are examples of events that change
a company’s assets, liabilities, or stockholders’ equity. Illustration 3-1 summarizes
the decision process companies use to decide whether or not to record economic
events.
ANALYZING TRANSACTIONS
In Chapter 1, you learned 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.
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.
Accounting Transactions 103
No Yes
Record
Don't
record
Yes
Record
Events
Criterion
Record/
Don’t Record
Discuss guided trip options Pay rent
with potential customer
Purchase computer
DELLDELLDELL
Is the financial position (assets, liabilities, or stockholders’ equity) of the company changed?
Bank
Home
Accounting
Ballence
Illustration 3-1
Transaction identification
process
1
Analyze the effect of
business transactions
on the basic accounting
equation.
Assets  Liabilities  Stockholders’ Equity
study objective
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104 chapter 3 The Accounting Information System
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.
Chapter 1 presented the financial statements for Sierra Corporation for its
first month. You should review those financial statements (on page 17) at this
time. To illustrate how economic events affect the accounting equation, we will
examine events affecting Sierra Corporation during its first month.
In order to analyze the transactions for Sierra Corporation, we will expand
the basic accounting equation. This will allow us to better illustrate the impact
of transactions on stockholders’ equity. Recall from the balance sheets in Chapters
1 and 2 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 affected when the company
earns revenue, incurs expenses, or pays dividends. Illustration 3-2 shows
the expanded equation.
If you are tempted to skip ahead after you’ve read a few of the following transaction
analyses, don’t do it. Each has something unique to teach, something you’ll
need later. (We assure you that we’ve kept them to the minimum needed!)
EVENT (1). INVESTMENT OF CASH BY STOCKHOLDERS. On October 1, cash of
$10,000 is invested in the business by investors (primarily your friends and family)
in exchange for $10,000 of common stock. This event is an accounting transaction
because it results in an increase in both assets and stockholders’ equity.
Assets  Liabilities  Stockholders’ Equity
$10,000 $4,000
 6,000
$ 4,000  $4,000
Assets Liabilities Stockholders' Equity  
Retained Earnings Common Stock 
Expenses Dividends Revenues  
Illustration 3-2 Expanded
accounting equation
Basic
Analysis
The asset Cash is increased $10,000, and stockholders’ equity (specifically
Common Stock) is increased $10,000.
Equation
Analysis
Assets  Liabilities  Stockholders’ Equity
Common
Cash  Stock
(1) $10,000 $10,000 Issued stock
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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:
Total assets are now $15,000, and liabilities plus stockholders’ equity also total
$15,000.
EVENT (3). PURCHASE OF OFFICE EQUIPMENT FOR CASH. On October 2, Sierra
purchased equipment by paying $5,000 cash to Superior Equipment Sales Co.
This event is a transaction because an equal increase and decrease in Sierra’s assets
occur.
The total assets are now $15,000, and liabilities plus stockholders’ equity also
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. This event is a transaction
because Sierra received cash (an asset) for guide services for multi-day trips
that are expected to be completed by Sierra 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.
Accounting Transactions 105
Basic
Analysis
Equation
Analysis
The asset Cash is increased $5,000, and the liability Notes Payable
is increased $5,000.
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Basic
Analysis
Equation
Analysis
The asset Equipment is increased $5,000; the asset Cash is decreased $5,000.
Assets  Liabilities  Stockholders’ Equity
Notes Common
Cash  Equipment  Payable  Stock
$15,000 $5,000 $10,000
(3) 5,000 $5,000
$10,000  $5,000  $5,000  $10,000
$15,000 $15,000
?????????????????????
Assets  Liabilities  Stockholders’ Equity
Notes Common
Cash  Payable  Stock
$10,000 $10,000
(2) 5,000 $5,000
$15,000  $5,000  $10,000
$15,000
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Later, when Sierra collects the $10,000 from the customer, Accounts Receivable
declines by $10,000, and Cash increases by $10,000.
106 chapter 3 The Accounting Information System
Since Sierra received cash prior to performance of the service, Sierra has a
liability for the work due.
EVENT (5). SERVICES PROVIDED FOR CASH. On October 3, Sierra received $10,000
in cash from Copa Company for guide services performed for a corporate event.
This event is a transaction because Sierra received an asset (cash) in exchange
for services.
Guide service is the principal revenue-producing activity of Sierra. Revenue
increases stockholders’ equity. This transaction, then, increases both assets
and stockholders’ equity.
Often companies provide services “on account.” That is, they provide service
for which they are paid at a later date. Revenue, however, is earned 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 provided these services on account rather than for cash. This event
would be reported using the accounting equation as:
Assets  Liabilities  Stockholders’ Equity
Accounts
Receivable  Revenues
$10,000 $10,000 Service Revenue
Basic
Analysis
The asset Cash is increased $1,200; the liability Unearned Service Revenue is increased $1,200 because
the service has not been provided yet. That is, when an advance payment is received, an unearned revenue
(a liability) should be recorded in order to recognize the obligation that exists.
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Equation
Analysis
Assets  Liabilities  Stockholders’ Equity
Equip- Notes Unearned Service Common
Cash  ment  Payable  Revenue  Stock
$10,000 $5,000 $5,000 $10,000
(4) 1,200 $1,200
$11,200  $5,000  $5,000  $1,200  $10,000
$16,200 $16,200
???????????????????????????????????
?????????????
Basic
Analysis The asset Cash is increased $10,000; the revenue Service Revenue is increased $10,000.
Assets  Liabilities  Stockholders’ Equity
Equip- Notes Unearned Common Retained Earnings
Cash  ment  Pay.  Serv. Rev.  Stock  Rev.  Exp.  Div.
$11,200 $5,000 $5,000 $1,200 $10,000
(5) 10,000 $10,000
$21,200  $5,000  $5,000  $1,200  $10,000  $10,000
$26,200 $26,200
Service
Revenue
Equation
Analysis
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Note that in this case, revenues are not affected by the collection of cash. Instead
we record an exchange of one asset (Accounts Receivable) for a different asset (Cash).
EVENT (6). PAYMENT OF RENT. On October 3, Sierra Corporation paid its office
rent for the month of October in cash, $900. This rent payment is a transaction
because it results in a decrease in an asset, cash.
Rent is an expense incurred by Sierra Corporation in its effort to generate
revenues. Expenses decrease stockholders’ equity. Sierra records the rent payment
by decreasing cash and increasing expenses to maintain the balance of the
accounting equation.
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.
Accounting Transactions 107
Assets  Liabilities  Stockholders’ Equity
Accounts
Cash Receivable
$10,000 $10,000
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?????????????
Equation
Analysis
Basic
Analysis
The expense account Rent Expense is increased $900 because the payment pertains only to the current
month; the asset Cash is decreased $900.
Assets  Liabilities  Stockholders’ Equity
Equip- Notes Unearned Common Retained Earnings
Cash  ment  Pay.  Serv. Rev.  Stock  Rev.  Exp.  Div.
$21,200 $5,000 $5,000 $1,200 $10,000 $10,000
(6) 900 $900
$20,300  $5,000  $5,000  $1,200  $10,000  $10,000  $900
$25,300 $25,300
Rent
Expense
Equation
Analysis
Basic
Analysis The asset Cash is decreased $600. The asset Prepaid Insurance is increased $600.
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????????????????????????????
Assets  Liabilities  Stockholders’ Equity
Prepaid Equip- Notes Unearned Common Retained Earnings
Cash  Insurance  ment  Pay.  Serv. Rev.  Stock  Rev.  Exp.  Div.
$20,300 $5,000 $5,000 $1,200 $10,000 $10,000 $900
(7) 600 $600
$19,700  $600  $5,000  $5,000  $1,200  $10,000  $10,000  $900
$25,300 $25,300
The balance in total assets did not change; one asset account decreased by the
same amount that another increased.
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108 chapter 3 The Accounting Information System
EVENT (8). PURCHASE OF SUPPLIES ON ACCOUNT. On October 5, Sierra purchased
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.
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.
EVENT (10). PAYMENT OF DIVIDEND. On October 20, Sierra paid a $500 dividend.
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.
EVENT (11). PAYMENT OF CASH FOR EMPLOYEE SALARIES. Employees have
worked two weeks, earning $4,000 in salaries, which were paid on October 26.
Equation
Analysis
Basic
Analysis The asset Supplies is increased $2,500; the liability Accounts Payable is increased $2,500.
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.)
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Assets  Liabilities  Stockholders’ Equity
Prepd. Equip- Notes Accounts Unearned Common Retained Earnings
Cash  Supplies  Insur.  ment  Pay.  Payable  Serv. Rev.  Stock  Rev.  Exp.  Div.
$19,700 $600 $5,000 $5,000 $1,200 $10,000 $10,000 $900
(8) $2,500 $2,500
$19,700  $2,500  $600  $5,000  $5,000  $2,500  $1,200  $10,000  $10,000  $900
$27,800 $27,800
????????????????????????
????????????????????????????????????????????????
Equation
Analysis
Basic
Analysis The dividends account is increased $500; the asset Cash is decreased $500.
Assets  Liabilities  Stockholders’ Equity
Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings
Cash  plies  Insur.  ment  Pay.  Pay.  Serv. Rev.  Stock  Rev.  Exp.  Div.
$19,700 $2,500 $600 $5,000 $5,000 $2,500 $1,200 $10,000 $10,000 $900
(10) 500  $500
$19,200  $2,500  $600  $5,000  $5,000  $2,500  $1,200  $10,000  $10,000  $900  $500
$27,300 $27,300
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Salaries Expense is an expense that reduces stockholders’ equity. This event is a
transaction because assets and stockholders’ equity are affected.
SUMMARY OF TRANSACTIONS
Illustration 3-3 (page 110) 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 stockholders’ equity. Remember
that Event (9) did not result in a transaction, so no entry is included 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 stockholders’ equity must be indicated.
Accounting Transactions 109
Why Accuracy Matters
While most companies record transactions very carefully, the reality is that
mistakes still happen. For example, bank regulators fined Bank One Corporation (now
Chase) $1.8 million because they felt that the unreliability of the bank’s accounting system
caused it to violate regulatory requirements.
Also, in recent years Fannie Mae, the government-chartered mortgage association, announced
a series of large accounting errors. These announcements caused alarm among
investors, regulators, and politicians because they fear that the errors may suggest larger,
undetected problems. This is important because the home-mortgage market depends on
Fannie Mae to buy hundreds of billions of dollars of mortgages each year from banks, thus
enabling the banks to issue new mortgages.
Finally, before a major overhaul of its accounting system, the financial records of Waste
Management Company were in such disarray that of the company’s 57,000 employees,
10,000 were receiving pay slips that were in error.
The Sarbanes-Oxley Act of 2002 was created to minimize the occurrence of errors like
these by increasing every employee’s responsibility for accurate financial reporting.
Investor Insight
?In order for these companies to prepare and issue financial statements, their accounting
equations (debits and credits) must have been in balance at year-end.
How could these errors or misstatements have occurred? (See page 158.)
Equation
Analysis
Basic
Analysis The asset Cash is decreased $4,000; the expense account Salaries Expense is increased $4,000.
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Assets  Liabilities  Stockholders’ Equity
Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings
Cash  plies  Insur.  ment  Pay.  Pay.  Serv. Rev.  Stock  Rev.  Exp.  Div.
$19,200 $2,500 $600 $5,000 $5,000 $2,500 $1,200 $10,000 $10,000 $ 900 $500
(11) 4,000  4,000 Salaries
$15,200  $2,500  $600  $5,000  $5,000  $2,500  $1,200  $10,000  $10,000  $4,900  $500 Expense
$23,300 $23,300
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110 chapter 3 The Accounting Information System
Assets  Liabilities  Stockholders’ Equity
Sup- Prepd. Equip- Notes Accts. Unearned Common Retained Earnings
Cash  plies  Insur.  ment  Pay.  Pay.  Serv. Rev.  Stock  Rev.  Exp.  Div.
(1)$10,000  $10,000 Issued stock
(2) 5,000 $5,000
(3) 5,000 $5,000
(4) 1,200 $1,200
(5) 10,000 $10,000 Service Revenue
(6) 900 $ 900 Rent Expense
(7) 600 $600
(8) $2,500  $2,500
(10) 500 $500 Dividends
(11) 4,000 4,000 Salaries Expense
$15,200  $2,500  $600 $5,000  $5,000  $2,500  $1,200  $10,000  $10,000  $4,900  $500
$23,300 $23,300
?????????????????????
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Illustration 3-3 Summary
of transactions
DECISION TOOLKIT
DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS
Has an accounting transaction
occurred?
Details of the event Accounting equation If the event affected assets,
liabilities, or stockholders’ equity,
then record as a transaction.
INFO NEEDED FOR DECISION
TRANSACTION
ANALYSIS
before you go on...
Do it! A tabular analysis of the transactions made by Roberta Mendez & Co.,
a certified public accounting firm, for the month of August is shown below. Each increase
and decrease in stockholders’ equity is explained.
Describe each transaction that occurred for the month.
Solution
1. The company issued shares of stock to stockholders for $25,000 cash.
2. The company purchased $7,000 of equipment on account.
3. The company received $8,000 of cash in exchange for services performed.
4. The company paid $850 for this month’s rent.
Assets  Liabilities  Stockholders’ Equity
Accounts Common Retained Earnings
Cash  Equipment  Payable  Stock  Revenue  Expenses
1.$25,000 $25,000 Issued stock
2. $7,000  $7,000
3. 8,000 $8,000 Service Revenue
4. 850 $850 Rent Expense
$32,150  $7,000  $7,000  $25,000  $8,000  $850
$39,150 $39,150
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Action Plan
• Analyze the tabular analysis to
determine the nature and effect
of each transaction.
• Keep the accounting equation in
balance.
• Remember that a change in an
asset will require a change in
another asset, a liability, or in
stockholders’ equity.
Related exercise material: BE3-1, BE3-2, BE3-3, Do it! 3-1, E3-1, E3-2, E3-3, and E3-4.
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The Account
Rather than using a tabular summary like the one in Illustration 3-3 for Sierra
Corporation, an accounting information system uses accounts. An account is an
individual accounting record of increases and decreases in a specific asset, liability,
stockholders’ equity, revenue, or expense item. For example, Sierra Corporation
has separate accounts for Cash, Accounts Receivable, Accounts Payable,
Service Revenue, Salaries Expense, and so on. (Note that whenever we are referring
to a specific account, we capitalize the name.)
In its simplest form, an account consists of three parts: (1) the title of the
account, (2) a left or debit side, and (3) a right or credit side. Because the alignment
of these parts of an account resembles the letter T, it is referred to as a
T account. The basic form of an account is shown in Illustration 3-4.
We use this form of account often throughout this book to explain basic accounting
relationships.
DEBITS AND CREDITS
The term debit indicates the left side of an account, and credit indicates the
right side. They are commonly abbreviated as Dr. for debit and Cr. for credit.
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 3-4.
The procedure of recording debits and credits in an account is shown in
Illustration 3-5 for the transactions affecting the Cash account of Sierra Corporation.
The data are taken from the Cash column of the tabular summary in
Illustration 3-3.
The Account 111
2
Explain what an account is
and how it helps in the
recording process.
study objective
3
Define debits and credits
and explain how they are
used to record business
transactions.
study objective
Left or debit side Right or credit side
Title of Account
Cr.
Dr.
Illustration 3-4 Basic
form of account
$10,000
5,000
–5,000
1,200
10,000
–900
–600
–500
–4,000
5,000
900
600
500
4,000
10,000
5,000
1,200
10,000
(Debits)
(Debit)
Balance
(Credits)
Cash Cash
$15,200
15,200
Tabular Summary Account Form
Illustration 3-5 Tabular
summary and account form
for Sierra Corporation’s
Cash account
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112 chapter 3 The Accounting Information System
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 red) is debited to Cash, and the
$5,000 payment of cash (in blue) is credited to Cash.
Having increases on one side and decreases on the other reduces recording
errors and 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. In other words, for each transaction, debits must
equal credits. The equality of debits and credits provides the basis for the doubleentry
accounting system.
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 Fidelity Investments
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.
Dr./Cr. Procedures for Assets and Liabilities
In Illustration 3-5 for Sierra Corporation, increases in Cash—an asset—were entered
on the left side, and decreases in Cash were 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
will have to be recorded opposite from increases and decreases in assets. Thus,
increases in liabilities must be entered on the right or credit side, and decreases
in liabilities must be entered on the left or debit side. The effects that debits and
credits have on assets and liabilities are summarized in Illustration 3-6.
International Note Rules for
accounting for specific events
sometimes differ across countries.
For example, European companies
rely less on historical cost and
more on fair value than U.S.
companies. Despite the differences,
the double-entry accounting
system is the basis of accounting
systems worldwide.
Debits Credits
Increase assets Decrease assets
Decrease liabilities Increase liabilities
Illustration 3-6 Debit
and credit effects—assets
and 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 3-7.
Illustration 3-7 Normal
balances—assets and
liabilities
Debit for
increase
Assets
Credit for
decrease
Normal
balance
Debit for
decrease
Liabilities
Credit for
increase
Normal
balance
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Knowing which is the normal balance in an account may help when you are
trying to identify errors. For example, a credit balance in an asset account, such
as Land, or a debit balance in a liability account, such as Salaries 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 (written a check that “bounced”). 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
In Chapter 1, we indicated 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. For example, 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 3-8.
Helpful Hint The normal balance
is the side where increases in the
account are recorded.
The Account 113
Illustration 3-9 Normal
balance—Common Stock
Debit for
decrease
Common Stock
Credit for
increase
Normal
balance
Debits Credits
Decrease Common Stock Increase Common Stock
Illustration 3-8 Debit
and credit effects—Common
Stock
Debits Credits
Decrease Retained Earnings Increase Retained Earnings
Illustration 3-10 Debit
and credit effects—Retained
Earnings
The normal balance in the Common Stock account may be diagrammed as
in Illustration 3-9.
RETAINED EARNINGS. Retained earnings is net income that is retained in the
business. It 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 3-10.
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114 chapter 3 The Accounting Information System
The normal balance for Retained Earnings may be diagrammed as in Illustration
3-11.
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 3-12, the Dividends account normally has a debit
balance.
REVENUES AND EXPENSES. When a company earns 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 3-13.
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 3-14.
Illustration 3-11 Normal
balance—Retained Earnings
Debit for
decrease
Retained Earnings
Credit for
increase
Normal
balance
Illustration 3-12 Normal
balance—Dividends
Debit for
increase
Dividends
Credit for
decrease
Normal
balance
Debits Credits
Decrease revenue Increase revenue
Increase expenses Decrease expenses
Illustration 3-13 Debit
and credit effects—revenues
and expenses
Illustration 3-14 Normal
balances—revenues and
expenses
Debit for
increase
Expenses
Credit for
decrease
Normal
balance
Debit for
decrease
Revenues
Credit for
increase
Normal
balance
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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 3-15 shows the relationships of the
accounts affecting stockholders’ equity.
The Account 115
Keeping Score
The Chicago Cubs baseball team has these major revenue and expense
accounts:
Revenues Expenses
Admissions (ticket sales) Players’ salaries
Concessions Administrative salaries
Television and radio Travel
Advertising Ballpark maintenance
Investor Insight
?Do you think that the Chicago Bears football team would be likely to have the
same major revenue and expense accounts as the Cubs? (See page 158.)
Illustration 3-15
Stockholders’ equity
Balance Sheet relationships
Assets
Liabilities
Stockholder’s equity
Common stock
Retained earnings
Income Statement
Revenues
Less: Expenses
Net income or net loss
Retained Earnings Statement
Begining retained earnings
Add: Net income
Less: Dividends
Ending retained earnings
Investments by stockholders
Net income retained in the business
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116 chapter 3 The Accounting Information System
SUMMARY OF DEBIT/CREDIT RULES
Illustration 3-16 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. No matter what the transaction, total debits
must equal total credits in order to keep the accounting equation in balance.
Illustration 3-16 Summary
of debit/credit rules
?? ?
?
?
?
? ? ?
?
? ? ? ? ? ? ? ? ? ? ? ? ? ?
? ? ?
? ? ?
? ? ? ? ? ?
Basic Assets + Stockholders’ Equity
Equation
Expanded
Basic Equation
Debit / Credit
Rules
= Liabilities
= + – + –
Dr.
+
Assets
Cr.
–
Dr.
–
Liabilities
Cr.
+
Dr.
–
Retained
Earnings
Cr.
+
Dr.
+
Dividends
Cr.
–
Dr.
–
Revenues
Cr.
+
Dr.
+
Expenses
Cr.
–
+
Dr.
–
Common
Stock
Cr.
+
DEBITS AND CREDITS
FOR BALANCE SHEET
ACCOUNTS
before you go on...
Do it! Kate Browne, president of Hair It Is Inc., has just rented space in a shopping
mall for the purpose of opening and operating a beauty salon. Long before opening
day and before purchasing equipment, hiring assistants, and remodeling the space, Kate
was strongly advised to set up a double-entry set of accounting records in which to record
all of her business transactions.
Identify the balance sheet accounts that Hair It Is Inc. will likely need to record the
transactions necessary to establish and open for business. Also, indicate whether the normal
balance of each account is a debit or a credit.
Solution
Hair It Is Inc. would likely need the following accounts in which to record the transactions
necessary to establish and ready the beauty salon for opening day: Cash (debit
balance); Equipment (debit balance); Supplies (debit balance); Accounts Payable (credit
balance); Notes Payable (credit balance), if the business borrows money; and Common
Stock (credit balance).
Action Plan
• First identify asset accounts for
each different type of asset
invested in the business.
• Then identify liability accounts
for debts incurred by the
business.
• Remember that Hair It Is Inc.
will need only one stockholders’
equity account for common stock
when it begins the business.
The other stockholders’ equity
accounts will be needed only
after the business is operating.
Steps in 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:
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.
4
Identify the basic steps in
the recording process.
study objective
Related exercise material: BE3-4, BE3-5, Do it! 3-2, and E3-7.
c03TheAccountingInformationSystem.qxd 8/3/10 1:33 PM Page 116
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 tape. 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 3-17.
Steps in the Recording Process 117
Illustration 3-17 The
recording process
Enter transaction in a journal Transfer journal information
to ledger accounts
The Recording Process
JOURNAL
JOURNAL
LEDGER
ASSETS LIABILITIES
Stockholders’ Equity
Analyze each transaction
Invoice
THE JOURNAL
Transactions are initially recorded in chronological order in journals before they
are transferred to the accounts. For each transaction the journal shows the debit
and credit effects on specific accounts. (In a computerized system, journals are
kept as files, and accounts are recorded in computer databases.)
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.
5
Explain what a journal is
and how it helps in the
recording process.
study objective
Assets  Liabilities  Stockholders’ Equity
Common
Cash  Stock
$10,000 $10,000 Issued stock
Ethics Note Business documents
provide evidence that transactions
actually occurred. International
Outsourcing Services, LLC, was
accused of submitting fraudulent
documents (store coupons) to
companies such as Kraft Foods
and PepsiCo for reimbursement of
as much as $250 million. Ensuring
that all recorded transactions are
backed up by proper business documents
reduces the likelihood of
fraudulent activity.
On October 1, Sierra issued common stock in exchange for $10,000 cash:
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118 chapter 3 The Accounting Information System
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 3-18.
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.
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.
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit
2012
Oct. 1 Cash 10,000
Common Stock 10,000
(Issued stock for cash)
1 Cash 5,000
Notes Payable 5,000
(Issued 3-month, 12% note payable for cash)
2 Equipment 5,000
Cash 5,000
(Purchased equipment for cash)
Illustration 3-18
Recording transactions in
journal form
On October 2, Sierra purchased equipment for $5,000:
Assets  Liabilities  Stockholders’ Equity
Cash Equipment
$5,000 $5,000
Assets  Liabilities  Stockholders’ Equity
Notes
Cash  Payable
$5,000 $5,000
On October 1, Sierra borrowed $5,000 by signing a note:
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THE LEDGER
The entire group of accounts maintained by a company is referred to collectively
as the ledger. The ledger keeps in one place all the information about changes
in specific account balances.
Companies may use various kinds of ledgers, but every company has a general
ledger. A general ledger contains all the assets, liabilities, stockholders’ equity,
revenue, and expense accounts, as shown in Illustration 3-19 (page 120). Whenever
we use the term ledger in this textbook without additional specification, it will mean
the general ledger.
Steps in the Recording Process 119
Boosting Microsoft’s Profits
Bryan Lee is head of finance at Microsoft’s Home and Entertainment Division.
In recent years the division lost over $4 billion, mostly due to losses on the original Xbox
videogame player. With the Xbox 360 videogame player, Mr. Lee hoped the division would
become profitable. He set strict goals for sales, revenue, and profit. “A manager seeking
to spend more on a feature such as a disk drive has to find allies in the group to cut
spending elsewhere, or identify new revenue to offset the increase,” he explains.
For example, Microsoft originally designed the new Xbox to have 256 megabytes
of memory. But the design department said that amount of memory wouldn’t support
the best special effects. The purchasing department said that adding more memory
would cost $30—which was 10% of the estimated selling price of $300. But the marketing
department “determined that adding the memory would let Microsoft reduce
marketing costs and attract more game developers, boosting royalty revenue. It would
also extend the life of the console, generating more sales.” Microsoft doubled the memory
to 512 megabytes.
Source: Robert A. Guth, “New Xbox Aim for Microsoft: Profitability,” Wall Street Journal (May 24, 2005), p. C1.
Accounting Across the Organization
?In what ways is this Microsoft division using accounting to assist in its effort to
become more profitable? (See page 158.)
Action Plan
• Record the transactions in a
journal, which is a chronological
record of the transactions.
• Make sure to provide a
complete and accurate
representation of the
transactions’ effects on the
assets, liabilities, and
stockholders’ equity of the
business.
The following events occurred during the first month of business of Hair
It Is Inc., Kate Browne’s beauty salon:
1. Issued common stock to shareholders in exchange for $20,000 cash.
2. Purchased $4,800 of equipment on account (to be paid in 30 days).
3. Interviewed three people for the position of beautician.
In what form (type of record) should the company record these three activities? Prepare
the entries to record the transactions.
Solution
Each transaction that is recorded is entered in the general journal. The three activities
are recorded as follows.
1. Cash 20,000
Common Stock 20,000
(Issued stock for cash)
2. Equipment 4,800
Accounts Payable 4,800
(Purchased equipment on account)
3. No entry because no transaction occurred.
JOURNAL ENTRIES
before you go on...
Do it!
6
Explain what a ledger is
and how it helps in the
recording process.
study objective
Related exercise material: BE3-6, BE3-9, Do it! 3-3, E3-6, E3-8, and E3-9.
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120 chapter 3 The Accounting Information System
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 accounts in a chart of accounts. They may create new
accounts as needed during the life of the business. Illustration 3-20 shows the chart
of accounts for Sierra Corporation 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.
Illustration 3-19 The
general ledger
Equipment
Land
Supplies
Cash
Interest Payable
Salaries Payable
Accounts Payable
Notes Payable
Salaries Expense
Service Revenue
Dividends
Retained Earnings
Common Stock
Individual
Asset
Accounts
Individual
Liability
Accounts
Individual
Stockholders’ Equity
Accounts
SIERRA CORPORATION—CHART OF ACCOUNTS
Stockholders’
Assets Liabilities Equity Revenues Expenses
Cash Notes Payable Common Stock Service Revenue Salaries Expense
Accounts Receivable Accounts Payable Retained Earnings Supplies Expense
Supplies Interest Payable Dividends Rent Expense
Prepaid Insurance Unearned Income Summary Insurance Expense
Equipment Service Revenue Interest Expense
Accumulated Depreciation— Salaries Payable Depreciation Expense
Equipment
Illustration 3-20 Chart
of accounts for Sierra
Corporation
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 3-21 through 3-31 on the following pages 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
7
Explain what posting is
and how it helps in the
recording process.
study objective
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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.
The Recording Process Illustrated 121
Illustration 3-21
Investment of cash
On October 1, stockholders invest $10,000 cash in an outdoor by stockholders
guide service company to be known as Sierra Corporation.
Event 1
Debit–Credit
Analysis
Debits increase assets: debit Cash $10,000.
Credits increase stockholders’ equity: credit Common Stock $10,000.
Journal
Entry
Posting Oct. 1 10,000
Cash Common Stock
Oct. 1 Cash
Common Stock
(Issued stock for cash)
10,000
10,000
Basic
Analysis
Equation
Analysis
The asset Cash is increased $10,000, and stockholders’ equity
(specifically Common Stock) is increased $10,000.
Assets
Cash
(1) +$10,000
=
=
Liabilities + Stockholders’ Equity
Common
Stock
+$10,000 Issued stock
Oct. 1 10,000
The diagrams in Illustrations
3-21 to 3-31 review the
accounting cycle. If you
would like additional
practice, an Accounting
Cycle Tutorial is available
on WileyPLUS. The
illustration to the left is an
example of a screen from
the tutorial.
Accounting Cycle Tutorial
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122 chapter 3 The Accounting Information System
Illustration 3-22 Issue
of note payable
Equation
Analysis
On October 1, Sierra borrows cash of $5,000 by signing
a 3-month, 12%, $5,000 note payable.
Basic
Analysis
The asset Cash is increased $5,000, and the liability Notes
Payable is increased $5,000.
Debit–Credit
Analysis
Debits increase assets: debit Cash $5,000.
Credits increase liabilities: credit Notes Payable $5,000.
Journal
Entry
Cash
Oct. 1 5,000
Notes Payable
Posting
Oct. 1 Cash
Notes Payable
(Issued 3-month, 12% note
payable for cash)
5,000
5,000
Oct. 1 10,000
1 5,000
Assets
Cash
(2) +$5,000
=
=
Liabilities + Stockholders’ Equity
Notes
Payable
+$5,000
Event 2
Illustration 3-23
Purchase of equipment
Equation
Analysis
On October 2, Sierra used $5,000 cash to purchase equipment.
Basic
Analysis
Debit–Credit
Analysis
Debits increase assets: debit Equipment $5,000.
Credits decrease assets: credit Cash $5,000.
The asset Equipment is increased $5,000; the asset Cash
is decreased $5,000.
Journal
Entry
Posting
Cash Equipment
Oct. 2 Equipment
Cash
(Purchased equipment
for cash)
5,000
5,000
Oct. 1 10,000
1 5,000
Oct. 2 5,000
+$5,000
Assets
Cash +
(3) –$5,000
= Liabilities +
Stockholders’
Equity
Equipment
Oct. 2 5,000
Event 3
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The Recording Process Illustrated 123
Equation
Analysis
On October 2, Sierra received a $1,200 cash advance from
R. Knox, a client, for guide services for multi-day trips that
are expected to be completed in the future.
Basic
Analysis
The asset Cash is increased $1,200; the liability Unearned
Service Revenue is increased $1,200 because the service has
not been provided yet. That is, when an advance payment is
received, an unearned revenue (a liability) should be recorded
in order to recognize the obligation that exists.
Debit–Credit
Analysis
Debits increase assets: debit Cash $1,200.
Credits increase liabilities: credit Unearned Service
Revenue $1,200.
Journal
Entry
Posting Oct. 1 10,000
1 5,000
2 1,200
Cash
Oct. 2 5,000 Oct. 2 1,200
Unearned Service Revenue
Oct. 2 Cash
Unearned Service Revenue
(Received advance from
R. Knox for future service)
1,200
1,200
Assets
Cash
(4) +$1,200
=
=
Liabilities + Stockholders’ Equity
Unearned
Serv. Rev.
+$1,200
Event 4
Illustration 3-25
Services provided for cash
Equation
Analysis
On October 3, Sierra received $10,000 in cash from
Copa Company for guide services provided in October.
Basic
Analysis
The asset Cash is increased $10,000; the revenue Service
Revenue is increased $10,000.
Debit–Credit
Analysis
Debits increase assets: debit Cash $10,000.
Credits increase revenues: credit Service Revenue $10,000.
Journal
Entry
Posting
Oct. 3 10,000
Cash Service Revenue
Oct. 2 5,000
Oct. 3 Cash
Service Revenue
(Received cash for services
provided)
10,000
10,000
Assets
Cash
(5) +$10,000
=
=
Liabilities + Stockholders’ Equity
Revenues
+$10,000 Service Revenue
Event 5
Oct. 1 10,000
1 5,000
2 1,200
3 10,000
Helpful Hint Many liabilities have
the word “payable” in their title.
But, note that Unearned Service
Revenue is considered a liability
even though the word payable is
not used.
Illustration 3-24
Receipt of cash in advance
from customer
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124 chapter 3 The Accounting Information System
Illustration 3-26
Payment of rent with cash
Equation
Analysis
Debit–Credit
Analysis
Debits increase expenses: debit Rent Expense $900.
Credits decrease assets: credit Cash $900.
On October 3, Sierra paid office rent for October in cash, $900.
Basic
Analysis
The expense account Rent Expense is increased $900 because
the payment pertains only to the current month; the asset
Cash is decreased $900.
Journal
Entry
Posting
Rent Expense
Oct. 3 Rent Expense
Cash
(Paid cash for October office
rent)
900
900
Oct. 1 10,000 Oct. 3 900
1 5,000
2 1,200
3 10,000
Cash
Oct. 2 5,000
3 900
Assets
Cash
(6) –$900
=
=
Liabilities + Stockholders’ Equity
Expenses
–$900 Rent Expense
Event 6
Illustration 3-27
Purchase of insurance
policy with cash
Equation
Analysis
Posting
Oct. 1 10,000
1 5,000
2 1,200
3 10,000
Cash
Oct. 2 5,000
3 900
4 600
Debit–Credit
Analysis
Debits increase assets: debit Prepaid Insurance $600.
Credits decrease assets: credit Cash $600.
On October 4, Sierra paid $600 for a 1-year insurance
policy that will expire next year on September 30.
Basic
Analysis
The asset Cash is decreased $600. Payments of expenses that
will benefit more than one accounting period are identified as
prepaid expenses or prepayments. When a payment is made,
an asset account is debited in order to show the service or
benefit that will be received in the future. Therefore, the
asset Prepaid Insurance is increased $600.
Journal
Entry
Oct. 4 600
Prepaid Insurance
Oct. 4 Prepaid Insurance
Cash
(Paid 1-year policy; effective
date October 1)
600
600
+$600
Assets
Cash +
(7) –$600
= Liabilities +
Stockholders’
Equity
Prepaid
Insurance
Event 7
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The Recording Process Illustrated 125
Equation
Analysis
Debit–Credit
Analysis
Debits increase assets: debit Supplies $2,500.
Credits increase liabilities: credit Accounts Payable $2,500.
On October 5, Sierra purchased an estimated 3 months of
supplies on account from Aero Supply for $2,500.
Basic
Analysis
The asset Supplies is increased $2,500; the liability Accounts
Payable is increased $2,500.
Journal
Entry
Posting Oct. 5 2,500
Supplies
Oct. 5 2,500
Accounts Payable
Oct. 5 Supplies
Accounts Payable
(Purchased supplies on
account from Aero Supply)
2,500
2,500
Assets
Supplies
(8) +$2,500
=
=
Liabilities + Stockholders’ Equity
Accounts
Payable
+$2,500
Event 8
Illustration 3-29 Hiring
of new employees
On October 9, Sierra hired four employees to begin work on
October 15. Each employee will receive a weekly salary
of $500 for a 5-day work week, payable every 2 weeks—first
payment made on October 26.
Basic
Analysis
An accounting transaction has not occurred. There is only an
agreement that the employees will begin work on October 15.
Thus, a debit–credit analysis is not needed because there is no
accounting entry. (See transaction of October 26 (Event II) for
first payment.)
Event 9
Illustration 3-28
Purchase of supplies on
account
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126 chapter 3 The Accounting Information System
Illustration 3-30
Payment of dividend
Equation
Analysis
Posting
Oct. 1 10,000
1 5,000
2 1,200
3 10,000
Cash
Oct. 2 5,000
3 900
4 600
20 500
Oct. 20 500
Dividends
Debit–Credit
Analysis
Debits increase dividends: debit Dividends $500.
Credits decrease assets: credit Cash $500.
On October 20, Sierra paid a $500 cash dividend to stockholders.
Basic
Analysis
The Dividends account is increased $500; the asset Cash is
decreased $500.
Journal
Entry
Oct. 20 Dividends
Cash
(Declared and paid a cash
dividend)
500
500
Assets
Cash
(10) –$500
=
=
Liabilities + Stockholders’ Equity
Dividends
–$500
Event 10
Illustration 3-31 Payment
of cash for employee
salaries
Equation
Analysis
Debit–Credit
Analysis
Debits increase expenses: debit Salaries Expense $4,000.
Credits decrease assets: credit Cash $4,000.
On October 26, Sierra paid employee salaries of $4,000 in cash.
(See October 9 event.)
Basic
Analysis
The expense account Salaries Expense is increased $4,000; the
asset Cash is decreased $4,000.
Journal
Entry
Posting
Oct. 26 Salaries Expense
Cash
(Paid salaries to date)
4,000
4,000
Cash
Oct. 26 4,000
Salaries Expense
Oct. 1 10,000
1 5,000
2 1,200
3 10,000
Oct. 2 5,000
3 900
4 600
20 500
26 4,000
Assets
Cash
(11) –$4,000
=
=
Liabilities + Stockholders’ Equity
Expenses
–$4,000 Salaries Expense
Event 11
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SUMMARY ILLUSTRATION OF
JOURNALIZING AND POSTING
The journal for Sierra Corporation for the month of October is summarized in
Illustration 3-32. The ledger is shown in Illustration 3-33 (on page 128) with all
balances highlighted in red.
The Recording Process Illustrated 127
Illustration 3-32 General
GENERAL JOURNAL journal for Sierra Corporation
Date Account Titles and Explanation Debit Credit
2012
Oct. 1 Cash 10,000
Common Stock 10,000
(Issued stock for cash)
1 Cash 5,000
Notes Payable 5,000
(Issued 3-month, 12% note payable for cash)
2 Equipment 5,000
Cash 5,000
(Purchased equipment for cash)
2 Cash 1,200
Unearned Service Revenue 1,200
(Received advance from R. Knox for future
service)
3 Cash 10,000
Service Revenue 10,000
(Received cash for services provided)
3 Rent Expense 900
Cash 900
(Paid cash for October office rent)
4 Prepaid Insurance 600
Cash 600
(Paid 1-year policy; effective date October 1)
5 Supplies 2,500
Accounts Payable 2,500
(Purchased supplies on account from Aero
Supply)
20 Dividends 500
Cash 500
(Paid a cash dividend)
26 Salaries Expense 4,000
Cash 4,000
(Paid salaries to date)
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128 chapter 3 The Accounting Information System
Supplies
Oct. 5 2,500
Bal. 2,500
Prepaid Insurance
Oct. 4 600
Bal. 600
Equipment
Oct. 2 5,000
Bal. 5,000
Notes Payable
Oct. 1 5,000
Bal. 5,000
Accounts Payable
Oct. 5 2,500
Bal. 2,500
Common Stock
Oct. 1 10,000
Bal. 10,000
Dividends
Oct. 20 500
Bal. 500
Service Revenue
Oct. 3 10,000
Bal. 10,000
Salaries Expense
Oct. 26 4,000
Bal. 4,000
Rent Expense
Oct. 3 900
Bal. 900
Illustration 3-33 General
ledger for Sierra Corporation GENERAL LEDGER
Cash
Oct. 1 10,000 Oct. 2 5,000
1 5,000 3 900
2 1,200 4 600
3 10,000 20 500
26 4,000
Bal. 15,200
Unearned Service Revenue
Oct. 2 1,200
Bal. 1,200
POSTING
before you go on...
Do it! Selected transactions from the journal of Faital Inc. during its first
month of operations are presented below. Post these transactions to T accounts.
Solution
Action Plan
• Journalize transactions to keep
track of financial activities
(receipts, payments, receivables,
payables, etc.).
• To make entries useful, classify
and summarize them by posting
the entries to specific ledger
accounts.
Date Account Titles Debit Credit
July 1 Cash 30,000
Common Stock 30,000
9 Accounts Receivable 6,000
Service Revenue 6,000
24 Cash 4,000
Accounts Receivable 4,000
Cash
July 1 30,000
24 4,000
Common Stock
July 1 30,000
Accounts Receivable
July 9 6,000 July 24 4,000
Service Revenue
July 9 6,000
Related exercise material: BE3-10, Do it! 3-4, and E3-11.
c03TheAccountingInformationSystem.qxd 8/3/10 1:33 PM Page 128
The Trial Balance
A trial balance lists accounts and their balances at a given time. A company
usually prepares a trial balance at the end of an accounting period. The accounts
are listed in the order in which they appear in the ledger. Debit balances are
listed in the left column and credit balances in the right column. The totals of
the two columns must be equal.
The trial balance proves the mathematical equality of debits and credits
after posting. Under the double-entry system this equality occurs when the
sum of the debit account balances equals the sum of the credit account balances.
A trial balance may also uncover errors in journalizing and posting. For example,
a trial balance may well have detected the error at Fidelity Investments
discussed in the Feature Story. In addition, a trial balance is useful in the
preparation of financial statements.
These are the procedures for preparing a trial balance:
1. List the account titles and their balances.
2. Total the debit column and total the credit column.
3. Verify the equality of the two columns.
Illustration 3-34 presents the trial balance prepared from the ledger of Sierra
Corporation. Note that the total debits, $28,700, equal the total credits, $28,700.
The Trial Balance 129
8
Explain the purposes of a
trial balance.
study objective
SIERRA CORPORATION
Trial Balance
October 31, 2012
Debit Credit
Cash $15,200
Supplies 2,500
Prepaid Insurance 600
Equipment 5,000
Notes Payable $ 5,000
Accounts Payable 2,500
Unearned Service Revenue 1,200
Common Stock 10,000
Dividends 500
Service Revenue 10,000
Salaries Expense 4,000
Rent Expense 900
$28,700 $28,700
Illustration 3-34 Sierra
Corporation trial balance
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. 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, or (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