1. The Accounting Cycle: Capturing Economic Events
Chapter 3
Chapter 3: The Accounting Cycle—Capturing Economic Events.

2. Learning Objective The Role of Accounting Records
Ledge and account, use of account
Accounting cycle and the first three steps
What is net income?
Realization and matching principle

3. The Role of Accounting Records
Establishes accountability for assets and transactions.
Keeps track of routine business activities.
Obtains detailed information about a particular transaction.
All accountants play a pivotal roll in establishing and maintaining economic information about a company. Much of Chapter Three will illustrate how an accounting system works. Most information is stored on computers -- and accounting information is no exception.
Accountants must be proficient in establishing and maintaining databases of financial information for a company. This information is used to prepare financial statements and other reports of interest to management and others.
Evaluates efficiency and performance within company.
Maintains evidence of a company’s business activities.

4. Accounts are individual records showing increases and decreases.
The Ledger
Accounts are individual records showing increases and decreases.
Cash
Accounts Payable
The entire group of accounts is kept together in an accounting record called a ledger.
An account is an individual record showing increases and decreases in the balance. Think of a checkbook as an account. In it, cash receipts and disbursements are maintained, in chronological order, as well as the current account balance.
The entire group of accounts for a particular business is called the ledger.
Capital Stock

5. The Use of Accounts
Increases are recorded on one side of the T account, and decreases are recorded on the other side.
Left or Debit Side
Right or Credit Side
Title of Account
Accountants often use a T account to represent a general ledger account. It is a quick way to analyze transactions before entering information in the journal. The left side of a T account is always called the debit side, and the right side is always called the credit side. This terminology comes from the time when the double-entry system was first developed. These terms are still used as a matter of convention. The words do not have any significant meaning other than they stand for the left and right side of a ledger account. Increases and decreases in an account balance are handled differently, depending upon the nature of the account.

6. Debit and Credit Entries
Receipts are on the debit side.
Payments are on the credit side.
Part I Here are the dates and amounts of transactions that impacted the cash account of JJ’s Lawn Service for the month of May. Part II Because cash is an asset, all receipts, or increases, should be placed on the debit, or left, side of the ledger account.
Part III If increases are placed on the left side of the account, all payments, or decreases, should be placed on the right, or credit, side of the account, according to the basic accounting rules for assets.
Part IV The balance in any account is the difference between total debits and credits. The balance is placed on the side with the greater dollar amount.
The balance is the difference between the debit and credit entries in the account.

7. Debit and Credit Entries
Debits and credits affect accounts as follows:
A = L + OE
ASSETS
Debit for Increase
Credit for Decrease
LIABILITIES
Debit for Decrease
Credit for Increase
EQUITIES
Debit for Decrease
Credit for Increase
To review, the left side of a ledger account is always called the debit, and the right side is always called the credit. Now, let’s move on to the mathematics of the double-entry system. Liabilities and equity have the opposite sign of assets. If liabilities were to move to the left side of the equation, it would read assets minus liabilities equal equity. As a convention of double-entry accounting, it’s been decided that a debit, or left side, of an asset account will represent an increase in the asset account balance. This convention determines all of the remaining math. Because liabilities and equity have the opposite sign of assets, a debit to a liability or equity account must mean a decrease and a credit means an increase. Instead of using the terms increase and decrease we use the terms debit and credit. It is important to remember whether we are talking about an asset, liability, or equity account for the meaning of a debit or a credit.
It may take a short while to become accustomed to using the terms debit and credit, but with practice the concept can be easily mastered. 13

8. Double Entry AccountingThe Equality of Debits and Credits
A = L + OE =
Debit balances
Credit balances
Accountants use the double-entry accounting system. This means that all transactions will have an equal dollar amount of debits and credits.
In the double-entry accounting system, every transaction is recorded by equal dollar amounts of debits and credits. 13

9. TRUE OR FALSE
1. The debit side of an account is the right side while the credit side is the left side.

10. Let’s record selected transactions for JJ’s Lawn Care Service in the accounts.
Let’s revisit many of the transactions of JJ’s Lawn Care, placing the amount of each transaction in the proper ledger account. Try to determine how the amounts will be posted before moving on to see the answer. 9

11. Cash increases $8,000 with a debit. Will Cash increase or decrease?
May 1: Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and received 800 shares of stock.
Cash increases $8,000 with a debit.
Will Cash increase or decrease?
Will Capital Stock increase or decrease?
Capital Stock increases $8,000 with a credit.
Part I Remember the transaction on May 1st when Jill Jones and her family invested $8,000 in JJ’s Lawn Care and received 800 shares of capital stock? Did the cash account increase or decrease? How about the capital stock account; did it increase or decrease?
Part II
The Cash account increased, so $8,000 was placed on the left, or debit, side of the ledger account. Remember, a debit to an asset account means an increase. The capital stock account was increased, or credited, for $8,000. Remember, a credit to an equity account represents an increase in the account.
This results in an equal debit and credit impact in this transaction, so we have followed the rules of double-entry accounting.
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12. May 2: JJ’s purchased a riding lawn mower for $2,500 cash.
Cash decreases $2,500 with a credit.
Will Cash increase or decrease?
Will Tools & Equipment increase or decrease?
Tools & Equipment increases $2,500 with a debit.
Part I Here is the transaction where JJ’s Lawn Care purchased the riding lawn mower for cash. Will the cash account increase or decrease? Will the tools and equipment account increase or decrease? This decision must be made before we can determine which side of the ledger account will be used to record the amount involved.
Part II
The cash account will decrease by $2,500. A decrease in an asset account is shown with a credit. This amount is put on the credit, or right, side of the ledger account.
The asset account tools and equipment increased. An increase is shown in an asset account with a debit. The $2,500 is put on the debit, or left, side of the ledger account.
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13. Truck increases $15,000 with a debit. Will Truck increase or decrease?
May 8: JJ’s purchased a $15,000 truck. JJ’s paid $2,000 in cash and issued a note payable for the remaining $13,000.
Truck increases $15,000 with a debit.
Will Truck increase or decrease?
Will Cash and Notes Payable increase or decrease?
Cash decreases $2,000 with a credit. Notes Payable increases $13,000 with a credit.
Part I JJ’s Lawn Care purchases a truck, paying $2,000 cash and signing a note for the balance of $13,000. Will the truck account increase or decrease? How about the cash and notes payable accounts; will they increase or decrease?
Part II
The truck account is an asset. An increases in an asset accounts is shown with a debit. The cost of the truck, $15,000, is placed on the debit, or left, side of the ledger account. The cash account will decrease by $2,000. A decrease in an asset account is shown with a credit. The payment is placed on the credit, or right, side of the cash ledger account. The notes payable account is a liability. The account balance increased. An increase in a liability account is shown with a credit. So, the $13,000 is placed on the credit, or right, side of the notes payable ledger account.
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14. May 11: JJ’s purchased some repair parts for $300 on account.
Tools & Equipment increases $300 with a debit.
Will Tools & Equipment increase or decrease?
Will Accounts Payable increase or decrease?
Accounts Payable increases $300 with a credit.
Part I JJ’s Lawn Care purchased repair parts for the riding lawn mower in the amount of $300. The company promised to pay the amount to the supplier at some point in the future. Will the tools and equipment account increase or decrease? Will the accounts payable account increase or decrease? Remember to determine the nature of the account involved when deciding increases or decreases. This decision will help place the amount on the correct side of the ledger accounts involved.
Part II
The asset account, tools and equipment, increased. Increases in asset accounts are shown on the debit, or left, side of the ledger account. So, $300 is placed on the debit side of the tools and equipment account. Accounts payable, a liability account, increased by $300. Increases in liability accounts are shown as credits. So, the amount involved is placed on the credit, or right, side of the accounts payable ledger account.
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15. Tools & Equipment decreases $150 with a credit.
May 18: JJ’s sold half of the repair parts to ABC Lawns for $150, a price equal to JJ’s cost. ABC Lawns agrees to pay JJ’s within 30 days.
Tools & Equipment decreases $150 with a credit.
Will Tools & Equipment increase or decrease?
Will Accounts Receivable increase or decrease?
Accounts Receivable increases $150 with a debit.
Part I Recall that JJ’s Lawn Care sold one-half of its repair parts for their original cost, or $150, to ABC Lawns. ABC Lawns agrees to pay the amount due in thirty days. Will the tools and equipment account increase or decrease? Will the accounts receivable account increase or decrease?
Part II
The asset account, tools and equipment, decreased by $150. Decreases in asset accounts are shown with a credit. So, the amount is placed on the credit, or right, side of the asset account, tools and equipment. The asset account, accounts receivable, increased by $150. Increases in asset accounts are shown as debits. So, the amount is placed on the debit, or left, side of the asset account, accounts receivable.
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16. The Journal
In an actual accounting system, transactions are initially recorded in the journal.
Transactions are initially recorded in the journal rather than the ledger account. The journal records transactions in chronological order. The ledger groups together all transactions that impact a particular account. When preparing a journal entry, always list debit accounts and amounts first and show credit accounts and amounts below the debits, indented slightly. Proper form requires that each journal entry be followed by a short description of the transaction. We skip a line after the description of the transaction before we start our next journal entry. 4

17. Posting Journal Entries to the Ledger Accounts
Posting simply means updating the ledger accounts for the effects of the transactions recorded in the journal.
At the end of the accounting period, transactions are posted from the journal into the ledger account. Posting is the process of systematically copying information from the journal to the ledger. Care must be taken when doing so, as it is easy to make mistakes. 4

18. Posting Journal Entries to the Ledger Accounts
Part I
A journal entry is shown here. Let’s see how to post this information from the journal to the ledger. Part II First, find the proper ledger account. In this case, the cash ledger account. Part II Next, copy the date to the ledger account. Part IV Finally, copy the amount from the debit column in the journal to the debit column in the ledger. Update the balance in the cash account. The current balance is eight thousand dollars. Now, let’s post the credit side of the journal entry. 4

19. Posting Journal Entries to the Ledger Accounts
Part I First, locate the capital stock account in the general ledger. Part II Next, copy the date from the journal entry to the proper column in the capital stock account. Part II Finally, copy the amount from the credit column in the journal to the credit column in the ledger. Update the account balance for the new posting. 4

20. Posting Journal Entries to the Ledger Accounts
The journal entry to record the purchase of the riding lawn mower is shown here. What will the cash ledger account look like after posting the cash portion of this journal entry?
Let’s see what the cash account looks like after posting the cash portion of this transaction for JJ’s Lawn Care Service. 4

21. Ledger Accounts After Posting
The posting was properly placed in the credit, or decrease, column of the cash ledger account. The balance in the account is updated and is currently $5,500.
This ledger format is referred to as a running balance. 4

22. Ledger Accounts After Posting
In accounting, a T account is frequently used to represent a ledger account. You can see the red lines that show how we get the term T account. The T account is a simple way to debit or credit a ledger account for illustration purposes T accounts are not part of the accounting system.
T accounts are simplified versions of the ledger account that only show the debit and credit columns. 4

23. TRUE OR FALSE
In a computerized accounting system journalizing may be done automatically but posting must be done by someone with an understanding of recording transactions.
The running balance form or the T account form is typically used in the trial balance to display the accounts and their amounts.

24. Net income always results in the increase of Owners’ Equity
What is Net Income?
Net income is not an asset it’s an increase in owners’ equity from profits of the business.
A = L + OE
Increase
Decrease
As income is earned, either an asset is increased or a liability is decreased.
Increase
Net income always results in the increase of Owners’ Equity
Part I Net income, the excess of revenues earned over expenses incurred, is not an asset. Net income increases owners’ equity by increasing retained earnings. Part II When a company earns income, assets must increase or liabilities must decrease to reflect the earnings process. Remember, when JJ’s Lawn Care rendered services to its customers the asset account, cash, increased and so did the owners’ equity account, retained earnings. Part III Net income always represents an increase in the owners’ equity of a company. 3

25. A = L + OE Retained Earnings
Capital Stock
Retained Earnings
Owners’ equity is comprised of capital stock and retained earnings. The retained earnings account represents all the accumulated earnings of the company since inception that have not been paid to owners.
The balance in the Retained Earnings account represents the total net income of the corporation over the entire lifetime of the business, less all amounts which have been distributed to the stockholders as dividends. 3

26. The Income Statement: A Preview
Here is the income statement of JJ’s Lawn Care we prepared in the previous chapter. Remember, the income statement is prepared for a period of time. In this case, it’s for the month ended May 31, 2009.
The income statement summarizes the profitability of a business for a specified period of time. 3

27. Accounting Periods Time Period Principle
To provide users of financial statements with timely information, net income is measured for relatively short accounting periods of equal length.
To provide timely and meaningful information to users of financial statements, business operations are divided into arbitrary time periods. Financial statements are usually prepared monthly. However, many transactions cross from one accounting period to the next. This creates a problem for accountants. 3

28. Increases owners’ equity.
Revenue and Expenses
The price for goods sold
and services rendered during a given accounting period.
Increases owners’ equity.
The costs of goods and services used up in the process of earning revenue.
Decreases owner’s equity.
Part I Revenues represent the price of goods sold or services rendered to customers during any given accounting period. Revenues increase owners’ equity. Part II Expenses are the cost of goods or services used up in the process of earning revenue. Accountants try to match expenses incurred with the revenues generated in an accounting period. Expenses decrease owners’ equity.

29. The Matching Principle: When To Record Revenue
Revenue should be recognized at the time goods are sold and services are rendered.
One of the basic concepts of accounting is that revenue should be recognized when the goods or services are sold to customers. This concept may take some time to understand, as most people are cash-based. That is, they recognize revenue when cash is received rather than when it is earned and recognize expenses when paid rather than when incurred.

30. The Matching Principle: When To Record Expenses
Expenses should be recorded in the period in which they are used up.
The matching principle states that we must match expenses with the period in which they are used.

31. The Accrual Basis of Accounting
Current Accounting Period
Future Accounting Period
Jan. 1, 2009
Dec. 1, 2009
Jan. 1, 2010
Dec. 1, 2010
Cash is received or paid here
The income statement reports revenue or expense here
But
The policy of recognizing revenue in the accounting records when it is earned and recognizing expenses when the related goods or services are used is called the accrual basis of accounting. The purpose of accrual accounting is to measure the profitability of the economic activities conducted during the accounting period. Revenue is offset with all of the expenses incurred in generating that revenue, thus providing a measure of the overall profitability of the economic activity. OR
The income statement reports revenue or expenses here
Cash is received or paid here
But

32. Debit and Credit Rules for Revenue and Expenses
Expenses decrease owners’ equity.
Revenues increase owners’ equity.
EQUITIES
Debit for Decrease
Credit for Increase
EXPENSES
Credit for Decrease
Debit for Increase
REVENUES
Debit for Decrease
Credit for Increase
Part I Let’s look more closely at the recording of revenues and expenses. To review, revenues increase owners’ equity and expenses decrease owners’ equity. Part II A decrease is shown in owners’ equity with a debit. Increases in expenses must be recorded as debits in a separate ledger account. Part III An increase in owners’ equity is shown with a credit. Increases in revenues must be recorded as credits in a separate ledger account.

33. Dividends Payments to owners decrease owners’ equity.
Owners’ investments increase owners’ equity.
EQUITIES
Debit for Decrease
Credit for Increase
DIVIDENDS
Credit for Decrease
Debit for Increase
CAPITAL STOCK
Debit for Decrease
Credit for Increase
Part I To review, payments to owners decrease owners’ equity and investments by owners increase owners’ equity. Part II Dividends represent payments to owners of a corporation. An increase in the dividend account must be shown with a debit. Part II Capital stock represents investments by owners of a corporation. An increase in the capital stock account must be shown with a credit.

34. We will also analyze a dividend transaction.
Let’s analyze the revenue and expense transactions for JJ’s Lawn Care Service for the month of May.
We will also analyze a dividend transaction.
Let’s look at recording revenues, expenses, and payments to owners of JJ’s Lawn Care. 9

35. Cash increases $750 with a debit. Will Cash increase or decrease?
May 29: JJ’s provided lawn care services for a client and received $750 in cash.
Cash increases $750 with a debit.
Will Cash increase or decrease?
Will Sales Revenue increase or decrease?
Sales Revenue increases $750 with a credit.
Part I Let’s reanalyze the transaction where JJ’s Lawn Care provided services to customers and received $750 cash. Will the cash ledger account increase or decrease? Will the sales revenue ledger account increase or decrease?
Part II
The asset account, cash, increased by $750. An increase is shown in an asset account on the debit, or left, side of the account. The revenue account, sales revenue, increased by $750. An increase in a revenue account is shown with a credit. So, the amount is placed on the credit, or right, side of the account.
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36. Cash decreases $50 with a credit. Will Cash increase or decrease?
May 31: JJ’s purchased gasoline for the lawn mower and the truck for $50 cash.
Cash decreases $50 with a credit.
Will Cash increase or decrease?
Will Gasoline Expense increase or decrease?
Gasoline Expense increases $50 with a debit.
Part I
Remember the transactions where JJ’s Lawn Care purchased gasoline for the riding mower and truck, paying $50 cash? Will the cash account increase or decrease? Will the gasoline expense account increase or decrease? This is the first transaction to include a separate expense account.
Part II
The asset account, cash, will decrease by $50. So, the decrease will show on the credit, or right, side of the cash account. The gasoline expense account increased by $50. Increases in expense accounts are shown as debits. The $50 increase in gasoline expense is shown on the debit, or left, side of the ledger account.
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37. May 31: JJ’s Lawn Care paid Jill Jones and her family a $200 dividend.
Cash decreases $200 with a credit.
Will Cash increase or decrease?
Will Dividends increase or decrease?
Dividends increase $200 with a debit.
Part I
Here is a new transaction. On May 31st, JJ’s Lawn Care paid a dividend to its owners in the amount of $200. Will the cash account increase or decrease? Will the dividend account increase or decrease?
Part II
The asset account, cash, decreased by $200. The decrease is shown on the credit, or left, side of the ledger account. The dividend account increased by $200. The increase is shown in the dividend account with a debit for $200. Remember, dividends reduce total owners’ equity.
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38. Now, let’s look at the Trial Balance for JJ’s Lawn Care Service for the month of May.
Let’s take a first look at a trial balance. On the next slides is the May 31st, trial balance of JJ’s Lawn Care. 9

39. Part I
A trial balance lists the balances of all accounts in the ledger. Remember that all transactions have an equal debit and credit impact. The total debit balance should be equal to the total credit balance according to the rules of double-entry bookkeeping.
Part II
The total of the debit balance accounts is $21,900. This is exactly equal to the total of the credit balance accounts. So, the books are in balance.
All balances are taken from the ledger accounts on May 31 after considering all of JJ’s transactions for the month. 4

40. The Accounting Cycle Journalize transactions.
Post entries to the ledger accounts.
Prepare trial balance.
Make end-of-year adjustments.
Prepare adjusted trial balance.
Prepare financial statements.
Prepare after-closing trial balance.
Journalize and post closing entries. 3

41. The Accounting Cycle in Perspective
Accountants spend much of their time focusing on the more analytical aspects of their discipline.
We view the accounting cycle as an efficient means of introducing basic accounting terms, concepts, processes, and reports. Please do not confuse your familiarity with this sequence of procedures with a knowledge of accounting. The accounting cycle is but one accounting process—and a relatively simple one at that. Accountants spend much of their time focusing on the more analytical aspects of their discipline. These include, for example:
Determining the information needs of decision makers.
Designing systems to provide the information quickly and efficiently.
Evaluating the efficiency of operations throughout the organization.
Assisting decision makers in interpreting accounting information.
Auditing, which is confirming the reliability of accounting information.
Forecasting the probable results of future operations. And,
Tax planning. 3

42. TRUE OR FALSE
4. Dividends are an expense of a corporation and reduce both total assets and stockholders' equity.
5. Dividends reduce owners' equity and therefore should be deducted from net income.
6. Every business transaction is recorded by a debit to a balance sheet account and a credit to an income statement account.

43. TRUE OR FALSE
Earning revenue increases owners' equity; therefore revenues are recorded with credit entries. Expenses reduce owners' equity and are recorded with debit entries.
Accounts are usually arranged in the ledger in financial statement order, that is, assets first, followed by liabilities, owners' equity, revenue, and expenses.
A debit to a ledger account refers to the entry of an amount on the right side of an account.

44. Case 3.2 Measuring Income Fairly
Kim Morris purchased Print Shop, Inc., a printing business, from Chris Stanley. Morris made a cash down payment and agreed to make annual payments equal to 40% of the company’s net income in each of the next three years. (Such “earns-outs ”are a common means of financing the purchase of a small business.) Stanley was disappointed, however, when Morris reported a first year’s net income far below Stanley’s expectations.

45. Case 3.2 Measuring Income Fairly
The agreement between Morris and Stanley did not state precisely how “net income” was to be measured. Neither Morris nor Stanley was familiar with accounting concepts. Their agreement stated only that the net income of the corporation should be measured in a “fair and reasonable manner”.

46. Case 3.2
In measuring net income, Morris applied the following policies:
1.Revenue was recognized when cash was received from customers. Most customers paid in cash, but a few were allowed 30-day credit terms.
2. Expenditure for ink and paper, which are purchased weekly, were charged directly to Supplies Expense, as were the Morris family’s weekly grocery and dry cleaning bills.

47. Case 3.2
3. Morris set her annual salary at $60,000, which Stanley had agreed was reasonable. She also paid salaries of $30,000 per year to her husband and to each of her two teenage children. These family members did not work in the business on a regular basis, but they did help out when things got busy.
4. Income taxes expense included the amount paid by the corporation (which was computed correctly), as well as the personal income taxes paid by various members of the Morris family on the salaries they earned working for the business.
5. The business had state-of-the-art printing equipment valued at $150,000 at the time Morris purchased it. The first-year income statement included a $150,000 equipment expense related to these assets.

48. Case 3.2
Instructions
Discuss the fairness and reasonableness of these income-measurement policies. (Remember, these policies do not have to conform to GAAP. But they should be fair and reasonable.)
Do you think that the net cash flow generated by this business (cash receipts less cash outlays) is higher or lower than the net income as measured by Morris? Explain.

49. After class learning guide
Self test questions
True or false
Exercise 3.1
Exercise 3.5

50. End of Chapter 3
End of chapter 3.