The accounting cyCLe:capturing economic events
HIGHLIGHTS OF THE CHAPTER
- The effects of business transactions are recorded in accounting records called journals and ledgers. The recorded data then are used to prepare financial statements and other accounting reports at periodic intervals.
- Transactions are recorded first in a journal, and the data is later transferred to the ledger. We can best illustrate the nature of these accounting records if we discuss the ledger first.
- A ledger account may be viewed as the smallest unit of storage in an accounting system. In a manual system, each ledger account is represented by a separate page in a binder. In a computerized system, of course, each unit of storage is maintained electronically using general ledger software. But each general ledger account can still be viewed separately.
- Each ledger account lists all of the increases and decreases in a particular financial statement account, and also indicates the account’s current “balance.”
- In its simplest form a ledger account may be viewed as having two sides. The left side of the account is called the debit side; the right side is called the credit side.
- Information entered on the left side of a ledger account are called debit entries. Information entered on the right side of a ledger account are called credit entries.
- For all asset accounts, increases are recorded by debit entries, and decreases are recorded by credit entries.
- For all liability accounts and owners' equity accounts, increases are recorded by credits, and decreases are recorded by debits.
- The debit and credit rules for recording revenue and expenses are based upon the changes they cause in owners' equity. Revenue increases owners' equity; therefore, revenue is recorded by credit entries. Expenses decrease owners' equity and are recorded debits.
- The double-entry system of accounting requires that equal dollar amounts of debits and credits be recorded for every transaction.
- Virtually every business maintains a journal as a record of “original” entry. A journal is a chronological listing of all transactions in the order they occur.
- The journal shows all information about each transaction: (a) the date of the transaction, (b) the accounts debited and credited, and (c) a brief explanation of the transaction.
- After a transaction has first been recorded in the journal, each debit and credit is later transferred to the appropriate ledger accounts. This transfer is called posting.
- Two things can cause changes in owners' equity: (a) owner investments and dividends, and (b) profits or losses resulting from the operation of the business.
- Profits increase owners' equity, and may either be distributed to the owners or reinvested in the business to help finance expansion and growth. Losses, however, reduce owners' equity, making the owners worse off, economically.
- Net income is the term most often used to describe increases in owners' equity resulting from profitable operations. Net loss is the term used to describe decreases in owners' equity resulting from unprofitable operations.
- Net income is computed by deducting expenses incurred during the accounting period from revenue earned during the period. Net income for each accounting period is reported in a financial statement called an income statement.
- An income statement covers a span of time, whereas a balance sheet shows a company’s financial position at one particular date. The need to relate net income to a period of time is called the time period principle.
- Revenue is the price charged to customers for goods sold and services rendered during the accounting period. Revenue is not necessarily “cash” flowing into a business. Rather, it is the amount “earned” during the period. Recognizing revenue as it is “earned” illustrates the realization principle. Cash received from customers may be received by a business before revenue is earned, after revenue is earned, or at the same time that revenue is earned.
- Expenses are the cost of goods and services incurred in the effort to generate revenue. Expenses are typically recorded as “resources” are used up, regardless of when payment for the resources is made. Thus, cash may be paid before resources are used up, after resources are used up, or at the same time that resources are used up.
- An income statement shows the revenue earned during the period and the expenses incurred during the period in generating that revenue. This policy of offsetting revenue with related expenses is called the matching principle.
- Businesses often purchase assets that will be “used up” over two or more accounting periods. The matching principle requires that an effort be made to allocate an appropriate portion of the asset’s cost as an expense in each period that the asset helps the business to earn revenue.
- At the end of the accounting period, when all entries in the journal have been posted to the ledger, the debit or credit balance of each account is computed. These balances are listed in a trial balance.
- The trial balance is a two-column schedule listing all of the accounts in the order they appear in the ledger. Debit account balances are shown in the left column and credit account balances are shown in the right column. Since the total of the debit balances should equal the total of the credit balances, the two columns will be equal if the ledger is in balance. However, the amounts shown are not necessarily the correct amounts.
- The trial balance is not a formal financial statement, but merely a preliminary step to preparing financial statements.
- The accounting procedures covered in this chapter were part of what is referred to collectively as the accounting cycle. The accounting cycle involves eight steps: (a) journalizing transactions (b) posting journal entries to ledger accounts, (c) preparing a trial balance, (d) making adjusting entries, (e) preparing an adjusted trial balance (f) preparing financial statements from the adjusted trial balance figures, (g) closing appropriate accounts, and (h) preparing an after-closing trial balance. In this chapter we have illustration d steps a-c of the accounting cycle. In Chapters 4 and 5, the remaining steps will be addressed.
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