From David H. Marshal and Wayne W. McManus. Accounting.
The bookkeeping/accounting process starts with transactions (economic interchanges between entities that are accounted for and reflected in financial statements) and culminates in the financial statements. This flow was illustrated in Chapter 2 as follows:
Procedures for sorting, classifying,
and presenting (bookkeeping)
„ . Financial
Transactions--------------------------- *- Selection of alternative methods ^statements
of reflecting the effects of certain
transactions (accounting)
This chapter presents an overview of bookkeeping procedures. Your objective is not to become a bookkeeper but to learn enough about the mechanical process of bookkeeping so you will be able to determine the effects of any transaction on the financial statements. This ability is crucial to the process of making informed judgments and decisions from the financial statements. Bookkeepers (and accountants) use some special terms to describe the bookkeeping process, and you will have to learn these terms. The bookkeeping process itself is a mechanical process, however, and once you understand the language of bookkeeping, you will see that the process is quite straightforward.
The Balance Sheet Equation—A Mechanical Key
You now know that the balance sheet equation expresses the equality between an entity's assets and the claims to those assets:
Assets = Liabilities + Owners' equity
For present illustration purposes, let us consider a firm without liabilities. What do you suppose happens to the amounts in the equation if the entity operates at a profit? Well, assets (perhaps cash) increase, and, if the equation is to balance (and it must), then clearly owners' equity must also increase. Yes, profits increase owners' equity, and to keep the equation in balance, assets will increase and/or liabilities will decrease. Every financial transaction that is accounted for will cause a change somewhere in the balance sheet equation, and the equation will remain in balance after every transaction.
EXHIBIT 4-1 Transaction Summary
Assets = Liabilities + Owners1 equity
Account Merchandise Equip- Notes Accounts Paid-in Retained Transaction Cash +Receivable + Inventory + ment = Payable + Payable + Capital + Earnings + Revenue — Expenses
1. +30 +30
2. -25 +25
3. +15 +15
4. -10 +20 +10
5. +2 +5 -7
6. _+_5 -_5
Total 17 + 0 + 20 + 18 = 15 + 10 + 30
7. Revenues +20 +20
7. Expenses -12 -12
8. +_i - 3
Total 17 + 20 + 8 + 18 = 15 + 13 + 30 +20 -15
+ 5 <------------------------------------------------------------------------------ '
You have already seen that a firm's net income (profit) or loss is the difference between the revenues and expenses reported on its income statement (Exhibit 2-2). Likewise, you have seen that net income from the income statement is reported as one of the factors causing a change in the retained earnings part of the statement of changes in owners' equity (Exhibit 2-3). The other principal element of owners' equity is the amount of capital invested by the owners, that is, the paid-in capital of Exhibit 2-3. Given these components of owners' equity, it is possible to modify the basic balance sheet equation as follows:
Assets = Liabilities + Owners' equity
Assets = Liabilities + Paid-in capital + Retained earnings
Retained
Assets = Liabilities + J^ + (b™gg + Revenues - Expenses
of period)
To illustrate the operation of this equation and the effect of several transactions, study how the following transactions are reflected in Exhibit 4-1. Note that in the exhibit some specific assets and liabilities have been identified within those general categories, and columns have been established for each.
Transactions
1. Investors organized the firm and invested $30. (In this example the broad category Paid-in Capital is used rather than Common Stock and, possibly,
Additional Paid-in Capital. There isn't any beginning balance in Retained Earnings because the firm is just getting started.)
2. Equipment costing $25 was purchased for cash.
3. The firm borrowed $15 from a bank.
4. Merchandise costing $20 was purchased for inventory; $10 cash was paid and $10 of the cost was charged on account.
5. Equipment that cost $7 was sold for $7; $2 was received in cash, and $5 will be received later.
6. The $5 account receivable from the sale of equipment was collected.
Each column of the exhibit has been totaled after transaction (6). Does the total of all the asset columns equal the total of all the liability and owners' equity columns? (They better be equal!)
The firm hasn't had any revenue or expense transactions yet, and it's hard to make a profit without them, so the transactions continue:
7. Sold merchandise inventory that had cost $12 for a selling price of $20; the sale was made on account(that is, on credit), and the customer will pay later. Notice that in Exhibit 4-1 this transaction is shown on two lines; one reflects the revenue of $20 and the other reflects the expense, or cost of the merchandise sold, of $12.
8. Wages of $3 earned by the firm's employees are accrued. This means that the expense is recorded even though it has not yet been paid. The wages have been earned by employees (the expense has been incurred), and are owed, but have not yet been paid; they will be paid in the next accounting period. The accrual is made in this period so that revenues and expenses of the current period will be matched (the matching concept), and net income will reflect the economic results of this period's activities.
Again, each column of the exhibit has been totaled, and the total of all the asset columns equals the total of all the liability and owners' equity columns. If the accounting period were to end after transaction (8), the income statement would report net income of $5, and the balance sheet would show total owners' equity of $35. Simplified financial statements for Exhibit 4-1 data after transaction (8) are presented in Exhibit 4-2.
Notice especially in Exhibit 4-2 how Net Income on the income statement gets into the balance sheet via the Retained Earnings section of owners' equity. In the equation of Exhibit 4-1, revenues and expenses were treated as a part of owners' equity to keep the equation in balance. For financial reporting purposes, however, revenues and expenses are shown in the income statement. In order to have the balance sheet balance, it is necessary that Net Income be reflected in the balance sheet, and this is done in Retained Earnings.
EXHIBIT 4-2 Financial Statements for Exhibit 4-1 Data_______
Exhibit 4-1 Data Exhibit 4-1 Data
Income Statement for Statement of Change in
Transactions (1) through (8) Retained Earnings
Revenues......................... $20 Beginning balance................. $ 0
Expenses......................... $ 15 Net income ........................ 5
Dividends................................................................................... (0)
Net income...................... $_5 —' Ending balance.............. |_5_ —
Exhibit 4-1 Data Balance Sheet after Transaction(8)
Assets Liabilities & Owners' Equity
Cash................................ $17 Note payable ................. $15
Accounts receivable........ $ 20 Accounts payable......... 13
Merchandise inventory........ 8 Current liabilities ........ $28
Current assets................. $45 Owners' equity:
Equipment...................... _18 Paid-in capital................ $30
Retained earnings _ 5
Total owners' equity................................................................... $35
Total liabilities & Total assets $63 owners' equity $_6
If any retained earnings are distributed to the owners as a dividend, the dividend does not show on the income statement, but is a deduction from retained earnings, shown in the statement of changes in retained earnings. This is because a dividend is not an expense (it is not incurred in the process of generating revenue). A dividend is a distribution of earnings to the owners of the firm.
What you have just learned is the essence of the bookkeeping process. Transactions are analyzed to determine which asset, liability, or owners' equity category is affected and how each is affected. The amount of the effect is recorded, the amounts are totaled, and financial statements are prepared.
Bookkeeping Jargon and Procedures
Because of the complexity of most business operations, and the frequent need to refer to past transactions, a bookkeeping system has evolved to facilitate the record-keeping process. The system may be manual or computerized, but the general features are virtually the same.
Transactions are initially recorded in a journal. A journal (derived from the French word jour, meaning day) is a day-by-day, or chronological, record of transactions. Transactions are then recorded in— posted to—a ledger.The ledger serves the function of Exhibit 4-1, but rather than having a large sheet with a column for each asset, liability, and owners1 equity category, there is an account for each category. In a manual bookkeeping system, each account is a separate page in a book much like a loose-leaf binder. Accounts are arranged in a sequence to facilitate the posting process. Usually the sequence is assets, liabilities, owners' equity, revenues, and expenses. A chart of accounts serves as an index to the ledger, and each account is numbered to facilitate the frequent written references that are made to it.
The account format that has been used for several hundred years looks like a "T." (In the following illustration, notice the T under the captions for Assets, Liabilities, and Owners' Equity.) On one side of the T, additions to the account are recorded, and on the other side of the T, subtractions are recorded. The account balance at any point in time is the arithmetic difference between the prior balance and the additions and subtractions. This is the same as in Exhibit 4-1 where the account balance shown after transactions (6) and (8) is the sum of the prior balance, plus the additions, minus the subtractions.
To facilitate making reference to account entries and balances (and to confuse neophytes), the left-hand side of a T-account is called the debit side, and the right-hand side of a T-account is called the credit side. In bookkeeping and accounting, debit and credit mean left and right, respectively, and nothing more (see Business Procedure Capsule 6—Bookkeeping Language in Everyday English). A record of a transaction involving a posting to the left-hand side of an account is called a debit entry. An account that has a balance on its right-hand side is said to have a credit balance.
The beauty of the bookkeeping system is that debit and credit entries to accounts, and account balances, are set up so that if debits equal credits, the balance sheet equation will be in balance. The key to this is that asset accounts will normally have a debit balance: Increases in assets are recorded as debit entries to these accounts, and decreases in assets are recorded as credit entries to these accounts. For liabilities and owners' equity accounts, the opposite will be true. To illustrate:
Assets = Liabilities + Owners' Equity
Debit Credit Debit Credit Debit Credit
Increases Decreases Decreases Increases Decreases Increases
+ -- + - +
Normal Normal Normal
balance balance balance
It is no coincidence that the debit and credit system of normal balances coincides with the balance sheet presentation illustrated earlier. In fact, the balance sheets illustrated so far have been presented in what is known as the account format. An alternative approach is to use the report format, in which assets are shown above liabilities and owners' equity.
Entries to revenue and expense accounts follow a pattern that is consistent with entries to other owners' equity accounts. Revenues are increases in owners' equity, so revenue accounts will normally have a credit balance, and will increase with credit entries. Expenses are decreases in owners' equity, so expense accounts will normally have a debit balance, and will increase with debit entries. Gains and losses are recorded like revenues and expenses, respectively.
The debit or credit behavior of accounts for assets, liabilities, owners' equity, revenues, and expenses is summarized in the following illustration:
Account Name Account number
Debit side Credit side
Normal balance for: Normal balance for:
Assets Liabilities
Expenses Owners' equity
Revenues
Debit entries increase: Credit entries increase:
Assets Liabilities
Expenses Owners' equity
Revenues
Debit entries decrease: Credit entries decrease:
Liabilities Assets
Owners' equity Expenses
Revenues
Referring to the transactions that were illustrated in Exhibit 4-1, a bookkeeper would say that in transaction (1), which was the investment of $30 in the firm by the owners, Cash was debited—it increased—and Paid-in Capital was credited, each for $30. Transac-
chart of accounts (p. 107) An index of the accounts contained in a ledger. closing the books (p. 118) The process of posting transactions and adjustments to the ledger and preparing the financial statements.
credit (p. 107) The right side of an account. A decrease in asset and expense accounts; an increase in liability, owners' equity, and revenue accounts.
debit (p. 107) The left side of an account. An increase in asset and expense accounts; a decrease in liability, owners' equity, and revenue accounts.
entry (p. 110) A journal entry or a posting to an account.
horizontal model (p. Ill) A representation of the balance sheet and income statement relationship that is useful for understanding the effects of transactions and adjustments on the financial statements. The model is:
Balance sheet Income statement
Assets = Liabilities + Owners' equity «—Net income = Revenues — Expenses
journal (p. 107) A chronological record of transactions.
journal entry (p. 110) A description of a transaction in a format that shows the
debit account(s) and amount(s) and credit account(s) and amount(s). ledger (p. 107) A book or file of accounts. on account (p. 105) Used to describe a purchase or sale transaction for which
cash will be paid or received at a later date. A "credit" transaction. post (p. 107) The process of recording a transaction in the ledger using a journal
as the source of the information recorded.
source document (p. Ill) Evidence of a transaction that supports the journal entry recording the transaction.
T-account (p. 107) An account format with a debit (left) side and a credit
(right) side. transactions (p. 103) Economic interchanges between entities that are accounted
for and reflected in financial statements. transaction analysis methodology (p. 118) The process of answering five questions
to ensure that a transaction is understood:
1. What's going on?
2. What accounts are affected?
3. How are they affected?
4. Does the balance sheet balance? (Do the debits equal the credits?)
5. Does my analysis make sense?
EXERCISES AND PROBLEMS
4-1. Record transactions and calculate financial statement amounts.
The transactions relating to the formation of Blue Co. Stores, Inc., and its first month of operations are shown below. Prepare an answer sheet with the columns shown. Record each transaction in the appropriate columns of your answer sheet. Show the amounts involved, and indicate how each account is affected (+ or -). After all transactions have been recorded, calculate the total of assets, liabilities, and owners' equity at the end of the month, and calculate the amount of net income for the month.
a. The firm was organized and the owners invested cash of $180.
ft. The firm borrowed $100 from the bank; a short-term note was signed.
с Display cases and other store equipment costing $75 were purchased
for cash. The original list price of the equipment was $90, but a discount
was received because the seller was having a sale.
d. A store location was rented, and $40 was paid for the first month's
rent.
e. Inventory of $150 was purchased; $90 cash was paid to the suppliers,
and the balance will be paid in 30 days.
/ During the first week of operations, merchandise that had cost $40 was
sold for cash of $65. g. A newspaper ad costing $20 was arranged for; it ran during the second
week of the store’s operations. The ad will be paid for in the next
month. h. Additional inventory costing $400 was purchased; cash of $120 was
paid, and the balance is due in 30 days. i. In the last three weeks of the first month, sales totaled $450, of which
$320 was sold on account. The cost of the goods sold totaled $300. /. Employee wages for the month totaled $35; these will be paid during
the first week of the next month.
were sheet:
Assets - Liabilities + Owners' equity
Accounts Merchandise Notes Accounts Paid-in Retained
action Cash + Receivable + Inventory + Equipment = Payable + Payable + Capital + Earnings + Revenues — Exf
4-2. Record transactions and calculate financial statement amounts.
The following are the transactions relating to the formation of Cardinal Mowing Services, Inc., and its first month of operations. Prepare an answer sheet with the columns shown. Record each transaction in the appropriate columns of your answer sheet. Show the amounts involved, and indicate how each account is affected (+ or —). After all transactions have been recorded, calculate the total of assets, liabilities, and owners' equity at the end of the month, and calculate the amount of net income for the month.
a. The firm was organized and the owners invested cash of $600. ft. The company borrowed $450 from a relative of the owners; a short-term note was signed.
c. Two lawn mowers costing $280 each, a trimmer costing $65, and a ga
can costing $9 were purchased for cash. The original list price of eac
mower was $340, but a discount was received because the seller wa
having a sale.
d. Gasoline, oil, and several packages of trash bags were purchased fc
cash of $52.
e. Advertising flyers announcing the formation of the business and
newspaper ad were purchased. The cost of these items, $75, will b
paid in 30 days.
/ During the first two weeks of operations, 19 lawns were mowed. Th
total revenue for this work was $210; $90 was collected in cash an
the balance will be received within 30 days. g. Employees were paid $150 for their work during the first two week h. Additional gasoline, oil, and trash bags costing $67 were purchase
for cash. ;'. In the last two weeks of the first month revenues totaled $260, (
which $90 was collected. /. Employee wages for the last two weeks totaled $190; these will b
paid during the first week of the next month. k. Trash bags that had cost $10 were sold to a customer for $15 cash. /. It was determined that at the end of the month the cost of the gasoline
oil, and trash bags still on hand was $8. m. A customer paid $40 due from mowing services provided during the first two weeks. The revenue for these services was recognized transaction .
Answer sheet:
Assets — Liabilities + Owners' equity
Accounts Notes Accounts Paid-in Retained
Transaction Cash + Receivable + Supplies + Equipment = Payable + Payable + Capital + Earnings + Revenues — Expenses
4-3. Write journal entries.
Write the journal entry(ies) for each of the transactions of Problem 4-
4-4. Write journal entries.
Write the journal entry(ies) for each of the transactions of Problem 4-
4-5. Record transactions and adjustments.
Prepare an answer sheet with the column headings shown below. Recoi the effect, if any, of the transaction entry or adjusting entry on the appri priate balance sheet category or on the income statement by entering tl account name, amount, and indicating whether it is an addition (+) < subtraction (-). Column headings reflect the expanded balance she equation; items that affect net income should not be shown as affected owners' equity. The first transaction is provided as an illustration.
a. During the month, the Supplies (asset) account was debited $1,800 for
supplies purchased. The cost of supplies actually used during the month
was $1,400.
b. Paid an insurance premium of $480 for the coming year. Prepaid Insurance was debited.
с Paid $3,200 of wages for the current month.
d. Received $250 of interest income for the current month.
e. Accrued $700 of commissions payable to sales staff for the current
month.
/ Accrued $130 of interest expense at the end of the month.
g. Received $2,100 on accounts receivable accrued at the end of the prior
month. h. Purchased $600 of merchandise inventory from a supplier on account. i. Paid $160 of interest expense for the month. j. Accrued $800 of wages at the end of the current month. k. Paid $650 of accounts payable.
Transaction/ Owners' Net
Situation Assets Liabilities Equity Income
a. Supplies Supplies Exp.
-1,400 -1,400
4-6.
Record transactions and adjustments.
Prepare an answer sheet with the column headings shown below. Record the effect, if any, of the transaction entry or adjusting entry on the appropriate balance sheet category or on the income statement by entering the account name, amount, and indicating whether it is an addition (+) or subtraction (-). Column headings reflect the expanded balance sheet equation; items that affect net income should not be shown as affecting owners' equity. The first transaction is provided as an illustration.
a. During the month, Supplies Expense was debited $1,800 for supplies
purchased. The cost of supplies actually used during the month was
$1,400.
b. During the month, the board of directors declared a cash dividend of
$2,500, payable next month.
с Employees were paid $2,100 in wages for their work during the first three weeks of the month.
d. Employee wages of $550 for the last week of the month have not been
recorded.
e. Merchandise that cost $680 was sold for $1,420. Of this amount, $1,100
was received in cash and the balance is expected to be received within
30 days.
f. A contract was signed with a newspaper for a $200 advertisement; the
ad ran during this month but will not be paid for until next month.
g. Revenues from services performed during the month totaled $5,100.
Of this amount, $2,600 was received in cash and the balance is expected
to be received within 30 days.
h. During the month, supplies were purchased at a cost of $220, and debited to the Supplies (asset) account. A total of $130 of supplier were used during the month.
i. Interest of $270 has been earned on a note receivable, but has not yet been received.
Transaction/ Owners' Net
Situation Assets Liabilities Equity Income
a. Supplies Supplies Exp.
+400 +400
4-7.
Record transactions and adjustments.
Enter the following column headings across the top of a sheet of paper:
Transaction/ Owners' Net
Situation Assets Liabilities Equity Income
Enter the transaction/situation number in the first column and show the effect, if any, of the transaction entry or adjusting entry on the appropriate balance sheet category or on the income statement by entering the amount and indicating whether it is an addition (+) or a subtraction (-). Column headings reflect the expanded balance sheet equation; items that affect net income should not be shown as affecting owners' equity. In some cases only one column may be affected because all of the specific accounts affected by the transaction are included in that category. Transaction a has been done as an illustration.
a. Provided services to a client on account; revenues totaled $550.
b. Paid an insurance premium of $360 for the coming year. An asset Prepaid Insurance was debited.
Prepaid Insurance was debited.
с Recognized insurance expense for one month from the above premium via a reclassification adjusting entry.
d. Paid $800 of wages accrued at the end of the prior month.
e. Paid $2,600 of wages for the current month.
/ Accrued $600 of wages at the end of the current month. g. Received cash of $1,500 on accounts receivable accrued at the end of the prior month.
Transaction/ Owners' Net
Situation Assets Liabilities Equity Income
a. +550 +550
4-8.
Record transactions and adjustments.
Enter the following column headings across the top of a sheet of paper:
Transaction/ Owners' Net
Situation Assets Liabilities Equity Income
Enter the transaction/situation number in the first column and show the effect, if any, of the transaction entry or adjusting entry on the appropriate balance sheet category or on the income statement by entering the amount and indicating whether it is an addition (+) or a subtraction (—). Column headings reflect the expanded balance sheet equation; items that affect net income should not be shown as affecting owners' equity. In some cases only one column may be affected because all of the specific accounts affected by the transaction are included in that category. Transaction a has been done as an illustration.
a. During the month, Supplies Expense was debited $1,800 for supplies purchased. The cost of supplies actually used during the month was $1,400. b. During the month. Supplies (asset) were debited $1,800 for supplies purchased. The total cost of supplies actually used during the month was $1,400. с Received $800 of cash from clients for services provided during the current month.
d. Paid $500 of accounts payable.
e. Received $300 of cash from clients for revenues accrued at the end of
the prior month.
/ Received $900 of interest income accrued at the end of the prior month. g. Received $1,200 of interest income for the current month. h. Accrued $700 of interest income earned in the current month. i. Paid $1,900 of interest expense for the current month. / Accrued $600 of interest expense at the end of the current month. k. Accrued $2,500 of commissions payable to sales staff for the current month.
Transaction/ Owners' Net
Situation Assets Liabilities Equity Income
a. +400 +400
4-9. Record transactions.
Use the horizontal model, or write the journal entry, for each of the following transactions that occurred during the first year of operations at Kissick Co.
a. Issued 20,000 shares of $5-par-value common stock for $1,000,000 in
cash.
b. Borrowed $500,000 from the Oglesby National Bank and signed a 12%
note due in two years.
с Incurred and paid $380,000 in salaries for the year.
d. Purchased $640,000 of merchandise inventory on account during the
year.
e. Sold inventory costing $580,000 for a total of $910,000, all on credit.
/ Paid rent of $110,000 on the sales facilities during the first 11 months of the year.