The Accounting Process

Table of Contents
1 Accounting Equation

7

Deferred Expenses and Revenues
2 Journal and Ledger

8

Closing Entries
3 Debits and Credits

9

Trial Balance
4 Normal Balances

10

Financial Statements
5 Review Questions 1

11

Review Questions 2
6 Adjusting entries-Accrued Expenses and Revenues

12

Glossary

Accounting Equation

The following is the accounting equation:

Assets = Liabilities + Owners' equity
This equation must be in balance at all times. Therefore, if one element in the equation changes, some other elements must also change to maintain the balance. Thus, at least two accounts are affected by every transaction. The term "double entry" in double entry accounting reflects the requirement that each transaction be recorded in at least two accounts.

For example, if land is purchased, one asset account (Land) has increased. To ensure that the accounting equation is in balance, at least one other account must change. If the land was purchased with cash, an asset account (Cash) must decrease by the same amount as the increase in the land account. If the land was purchased with a signed note, a liability account increases to ensure that the accounting equation stays in balance. What if the land was purchased by a partial payment of cash with a note for the remainder? Then two accounts other than Land are affected: Cash decreases and Notes Payable increases. Together, these changes must neutralize the effect of the increase in the Land account.

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Journal and Ledger

The JOURNAL is a book in which transactions are recorded in the order that they occur. Each transaction is recorded in the journal after being analyzed to determine which accounts it affects, the amount of the effect, and whether the transaction increases or decreases these accounts.

After the transaction has been recorded in the journal, it is posted to the LEDGER. The general ledger is used to record the impact of transactions on accounts by recording the increases and decreases to each account into columns. These columns form the shape of the letter "T." Thus, accounts in the general ledger are also referred to as T-accounts. One T-account is used for each account in the accounting books.

Both the general journal and the general ledger contain information about accounts and the amount by which these accounts are debited or credited. They differ, however, in the way the information is organized. In the journal, the information is organized in chronological order (that is, transactions are recorded in the order in which they occur). In the general ledger, the information is organized by account. Thus, accountants use the general ledger to calculate balances in different accounts.

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Debits and Credits

The column on the left side of the T-account is called the DEBIT side. The column on the right side is called the CREDIT side. The side used for recording increases is based on the accounting equation:

Assets= Liabilities + Owners' equity
Assets are on the left side of the equation. Correspondingly, increases in assets are recorded in the column on the left (debit) side.

For example, when a firm collects cash, the cash balance increases. This is recorded by posting an entry on the left-hand side of the Cash account; that is, the Cash account is debited for increases in the cash balance. Conversely, when cash is paid, the cash balance decreases. This is recorded by an entry on the opposite, or right-hand side, of the Cash account; that is, the Cash account is credited for decreases.

Liabilities and owners' equity appear on the right side of the accounting equation. Hence, increases in liabilities and owners' equity are recorded on the right (credit) side.

For example, assume that inventory was purchased on credit. An asset (called inventory) increases, so the Inventory account is debited. However, this purchase has not yet been paid for, so a liability exists. Accounts payable, a liability, has increased. This is recorded by posting an entry on the right-hand side of the Accounts payable account. Conversely, when the supplier is paid later, the liability decreases. This is recorded by an entry on the opposite side: the Accounts Payable account is debited when the supplier is paid, decreasing the liability.

Owners' equity is increased when the business earns revenue. We also know that owners' equity is credited for increases. Thus, revenues are recorded by crediting the appropriate revenue accounts.

Owners' equity is decreased when the business incurs an expense. Owners' equity is debited for decreases. Thus, expenses are recorded by debiting the appropriate expense accounts.

Dividends (or drawings) are not expenses; they are simply a return of capital to the shareholders (owners). Thus, dividends also have the effect of decreasing owners' equity. Hence, dividends are recorded by debiting the Dividends account.

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Normal Balances

Assets are increased by debits. Therefore, the normal balance in asset accounts is a debit balance. The Cash account is debited when cash is received, and is credited when cash is paid. A credit balance in the Cash account implies that the organization has a negative amount of cash, which is not possible. Thus, we expect a debit balance in the Cash account.

Liabilities are increased by credits. When amounts owed to creditors or suppliers increase, a liability account is credited. When a payment is made to creditors (suppliers), the liability is debited. Thus, the normal balance in a liability account is a credit balance.

Owners' equity is increased by credits. Owners' investments are recorded using the Capital Stock account. Since owners' investments increase owners' equity, the Capital Stock account is credited. Thus, Capital Stock account has a credit balance.

Distributions to owners are recorded in the Dividends (Drawings) account. When dividends are declared, owners' equity in the business decreases and the Dividends account is debited.

Normally, the Retained Earnings account has a credit balance. However, if a business has had losses, the Retained Earnings account can have a debit balance.

(Note that in the case of a sole proprietorship, an Owners' Equity account is credited to record owner investments. Thus, the normal balance in the Capital account is a credit balance. When a sole proprietor withdraws money, the Drawings account is debited since withdrawals reduce owner's equity. Hence, the normal balance in the Drawings account is a debit balance.)

Revenues increase owners' equity. A revenue account is credited to show this increase in owners' equity. Thus, revenue accounts typically have a credit balance.

Expenses decrease owners' equity. An expense account is debited to record this decrease in owners' equity. Thus, expense accounts typically have a debit balance.

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Review Questions - 1

Fill in the blanks. Use a term from the list given below.

Terms:
assets cash credited
debited liabilities notes payable
Enter answers in lowercase.

1.   are debited for increases.

2.   are credited for increases.

3.  An expense account is  when a business pays rent for the period.

4.  A revenue account is  when goods are sold.

5.   is debited when a business repays money to a creditor.

6.   is debited when a business borrows money from a creditor.


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Adjusting Entries-Accrued Expenses and Revenues

ADJUSTING ENTRIES are prepared at the end of a fiscal period. These entries are required when a business uses accrual accounting because of the timing differences between the flow of cash and the recognition of revenues or expenses.

For example, the cost of employee services is recognized as an expense in the period in which the services are provided regardless of when cash is paid to employees. Thus, salaries earned by employees in April are recorded as expense in April even if the cash is paid in May.

ACCRUED EXPENSES occur when expenses are recognized before cash is paid. Accrual accounting requires expenses incurred during a period to be recorded in that period even if the cash is paid later.

Example:
Assume that a company advertised during December 2002 but has not received a bill or paid for the advertisement, which cost $500. The advertising costs incurred during the year 2002 must be recorded as expense for that year, even if the payment is made in a later period. Hence, an advertising expense of $500 is accrued on December 31, 2002. Since a payment of $500 must be made in the future, a liability (Accounts Payable) is recognized for this amount. The journal entry follows:

Account

Debit

Credit

Advertising Expense

$ 500

 
   Accounts Payable  

$ 500

When the payment for the advertisement is made later, the liability will be reduced.

Other examples of accrued expenses include the following:

Accrued Salaries: Salaries earned by employees in a period to be paid in a later period are called accrued salaries. Assume that $2,000 of salaries earned by employees in December 2002 will be paid in January 2003. The cost of services provided by employees during 2002 must be recorded as an expense for 2002, even if the payment is made in a later period. Hence, a salaries expense of $2,000 is accrued on December 31, 2002. Since salaries of $2,000 must be paid in the future, a liability (Salaries Payable) is recognized for this amount. The journal entry follows:

Account

Debit

Credit

Salaries Expense

$ 2,000

 
   Salaries Payable  

$ 2,000

When the salary is paid, the liability will be reduced.

Accrued Interest: Interest is accrued for the use of money borrowed during a period if the cash payment for interest will be made in a future period. This transaction is an example of an accrued expense, since the expense is recognized before the cash is paid. Interest is calculated using the following formula:

i = p * t * r / 100
p is the principal.
r is the annual rate of interest.
t is the time in years for which the interest is being calculated.
i is the interest for this time period.

ACCRUED REVENUES occur when revenues are recognized before cash is received. Assume that an organization provided services in the amount of $500 during December 2002. The organization has not billed the customer or recorded the sale of services. Accrual accounting recognizes revenue when goods are provided. Since services were provided in December, revenue must be recognized in December. Thus, an adjusting entry is prepared on December 31, 2002. The journal entry follows:

Account

Debit

Credit

Accounts Receivable

$ 500

 
   Service Revenue  

$ 500



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Deferred Expenses and Revenues

DEFERRED EXPENSES occur when expenses are recognized after cash is paid. Under accrual accounting, expenses incurred during a period must be recorded in that period even if the cash was paid earlier.

For example, when an organization purchases supplies, it records them as an asset. Supplies expense is recognized when the supplies are used, not when cash is paid to purchase them. Supplies expense reflects the amount of supplies consumed during a period. An adjusting entry is prepared to record the supplies used. Note that the Supplies account is credited by the amount of supplies used.

Example:
Assume that the inventory of supplies on hand as of January 1, 2002, was $400. During the year, $1,500 of supplies were purchased, and the ending inventory of supplies on December 31, 2002 was $300. We calculate the amount of supplies used during the year as follows:

Supplies consumed = Beginning inventory + Purchases - Ending inventory.
Thus, the amount of supplies consumed in 2002 = $1,600 ($400 + $1,500 - $300). This must be recognized as an expense for the period. Since expenses reduce owners' equity, Salaries Expense is debited; since the balance of supplies is reduced when supplies are consumed, the Supplies account is credited. The journal entry follows:

Account

Debit

Credit

Supplies Expense

$ 1,600

 
   Supplies  

$ 1,600

Another example of deferred expense is a prepaid expense. For example, if the rent on a building is paid in advance, an asset called Prepaid Rent is increased. Rent expense is recorded at the end of the period, and the asset Prepaid Rent is reduced by the same amount.

Example:
A company pays $4,800 as one year's rent in advance on October 1, 2002. This may be recorded as prepaid rent (an asset) at the time of the initial cash payment. The rent for one month is $400 ($4,800/12). Since three months have elapsed from October 1 to December 31, $1,200 of rent expense must be recognized. Thus, the journal entry to record the rent expense is as follows:

Account

Debit

Credit

Rent Expense

$ 1,200

 
   Prepaid rent  

$ 1,200

Depreciation is another example of a deferred expense. Accrual accounting records resources such as equipment as assets when they are purchased. The cost of the asset is allocated to expense over the life of the asset.

To record depreciation, the Depreciation Expense account is debited to reflect the amount of the cost of the asset allocated during the period. Furthermore, the value of the asset must be reduced by the amount recognized as being allocated as expense for the period. Instead of reducing the asset account directly, the Accumulated Depreciation account is credited. The Accumulated Depreciation account represents the value of the asset allocated to depreciation from the time the asset was acquired.

Example:
Assume that a company purchases equipment for $10,000 on January 1, 1998. The equipment's useful life is 10 years. An adjusting entry is prepared at the end of each year of the asset's useful life. In this example, depreciation expense of $1,000 is recorded every year. The journal entry follows:

Account

Debit

Credit

Depreciation Expense

$ 1,000

 
   Accumulated Depreciation  

$ 1,000

The balance in the Accumulated Depreciation account represents the total amount by which the asset has been depreciated. Thus, the balance in the Accumulated Depreciation account at the end of 1999 is $2,000; the balance in the Accumulated Depreciation account at end of year 2002 is $5,000.

DEFERRED REVENUES occur when revenues are recognized after cash has been collected from customers. When cash is collected in advance, the business has not yet provided the goods or services to the customer. Hence, no revenue has been earned. The company owes goods and services to the customer in the future. Thus, a liability (Unearned Revenue) is recorded for the amount of goods or services owed. An adjusting entry is prepared at the end of the period for the amount of goods or services provided during that period.

Example:
A firm receives $4,800 in magazine subscriptions in advance for one year on September 1, 2002. The transaction is recorded on September 1, 2002, and the adjusting entry on December 31, 2002.

On September 1, 2000, the company must record the receipt of cash from customers. However, it has not yet provided the goods or services to this customer so no revenue has been earned. The company owes the customer $4,800 worth of magazines. A liability (Unearned Revenue) must be recognized at the time cash is received.

At the end of the year, the company has satisfied its obligations for four of the 12 months (September through December). Thus, the company must reduce its liability (Unearned Revenue) and record Revenue of $1,600 ($4,800 x 4/12). The journal entry follows:

Account

Debit

Credit

Unearned Revenue

$ 1,600

 
   Sales Revenue  

$ 1,600

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Closing Entries

The final step in the accounting cycle involves preparing and posting closing entries. Some accounts accumulate information for one accounting period. For example, a revenue account shows the amount of revenue earned during that period. The balance in such accounts must be reset to zero at the beginning of each accounting period. Closing entries are prepared to reset such accounts to zero.

Revenue and expense accounts are first closed to a temporary account called Income Summary. Revenue accounts have a credit balance. To reset the revenue account to zero, it must be debited by an amount equal to its current balance. Income Summary is credited by an equal amount. Expense accounts have a credit balance. To reset an expense account to zero, it must be credited by an amount equal to its current balance. Income Summary is debited by an amount equal to the total expenses.

The balance in the Income Summary account is transferred to the Retained Earnings amount. If the business earned a profit during the period, the Income Summary account has a credit balance equal to the net income for the period after closing the revenue and expense accounts. To close the Income Summary account, it must be debited by the amount of the net income. Retained Earnings is credited by the same amount.

Note that it is not necessary to have the intermediate step of closing the revenue and expense accounts to the Income Summary account and then transferring the balance to the Retained Earnings account. The revenue and expense accounts can be closed directly to the Retained Earnings account.

The final step in the closing process involves the Dividends account. Owners may receive cash payments (dividends) from the business. Corporations use the Dividends account to record distributions to owners during a period. At the end of the period the balance in the Dividends account must also be reset to zero. This balance is subtracted from the Retained Earnings account.

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Trial Balance

After all the transactions have been posted, a trial balance is prepared. A trial balance lists each account in the general ledger and its balance (debit or credit) as of a particular date. The total in the debit column must equal the total in the credit column. If the two amounts do not match, there must be an error in the recording. For example, if only the debit part of an entry is posted, the two amounts will not match.

A trial balance can be prepared before or after the closing entries. Note that after the closing entries have been prepared, the revenue, expense, and dividend accounts will have been closed (that is, have zero balance). Thus, a post-closing trial balance has only asset, liability, and owners' equity accounts.

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Financial Statements

An INCOME STATEMENT indicates the profitability of a business over a period of time. It shows the revenue and expense account balances. The difference between revenues earned during a period and the expenses for the period represents the net income for the period. The heading of the statement shows the name of the organization, the title of the statement, and the period for which the statement is being prepared.

The STATEMENT OF OWNERS' EQUITY shows the changes to owners' equity. Owners' equity includes Capital Stock and Retained Earnings. Retained earnings represents the portion of owners' equity created by earning net income and reinvesting the profits in the business. The net income minus any dividends declared represents the reinvested profits. The reinvested profits are added to the beginning retained earnings balance. This gives the following relationship:

Ending retained earnings = Beginning retained earnings + Net income - Dividends

Note that in the case of a corporation, the reinvested profits are added to Retained Earnings, not Common Stock. The Common Stock account is credited only when new shares are issued to stockholders; it represents new investments as opposed to the reinvestment of profits.

A BALANCE SHEET presents the financial position of an organization as of a particular date. It shows the assets, liabilities, and owners' equity balances for a company at the end of a fiscal period. Note that the balance in the Retained Earnings account is the ending balance shown in the statement of retained earnings. The heading of the statement shows the name of the organization, the title of the statement, and the date at which the statement is being prepared.

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Review Questions - 2
Fill in the blanks. Use a term from the list given below.

Terms:
Accrued Accumulated Depreciation Adjusting
closing Deferred Depreciation Expense
Enter answers in lower case.


1. entries are required for accrual accounting because of timing differences between cash flows and the recognition of revenues or expenses.

2. revenues occur when revenues are recognized after cash is collected from customers.

3. expenses occur when expenses are recognized before cash is paid.

4. The final step in the accounting cycle involves preparing and posting the entries.

5. When depreciation expense is recorded, the  account is debited.

6. When depreciation expense is recorded, the  account is credited.

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Glossary

Accounting equation Debit
Accrued expenses Deferred expenses
Accrued revenues Deferred revenues
Adjusting entries Income statement
Balance sheet Journal
Closing entries Ledger
Credit Trial balance

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