Recording Business Transactions

Learning objectives

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Salary potential of accountants

The account and rules of debit and credit

A business may engage in thousands of transactions during a year. An accountant classifies and summarizes the data in these transactions to create useful information.

Steps in recording business transactions

Look at Exhibit 5 to see the steps in recording and posting the effects of a business transaction. Note that source documents provide the evidence that a business transaction occurred. These source documents include such items as bills received from suppliers for goods or services received, bills sent to customers for goods sold or services performed, and cash register tapes. The information in the source document serves as the basis for preparing a journal entry. Then a firm posts (transfers) that information to accounts in the ledger.

You can see from Exhibit 5 that after you prepare the journal entry, you post it to the accounts in the ledger. However, before you can record the journal entry, you must understand the rules of debit and credit. To teach you these rules, we begin by studying the nature of an account.

Fortunately, most business transactions are repetitive. This makes the task of accountants somewhat easier because they can classify the transactions into groups having common characteristics. For example, a company may have thousands of receipts or payments of cash during a year. As a result, a part of every cash transaction can be recorded and summarized in a single place called an account.

An account is a part of the accounting system used to classify and summarize the increases, decreases, and balances of each asset, liability, stockholders' equity item, dividend, revenue, and expense. Firms set up accounts for each different business element, such as cash, accounts receivable, and accounts payable. Every business has a Cash account in its accounting system because knowledge of the amount of cash on hand is useful information.

Accountants may differ on the account title (or name) they give the same item. For example, one accountant might name an account Notes Payable and another might call it Loans Payable. Both account titles refer to the amounts borrowed by the company. The account title should be logical to help the accountant group similar transactions into the same account. Once you give an account a title, you must use that same title throughout the accounting records.

The number of accounts in a company's accounting system depends on the information needs of those interested in the business. The main requirement is that each account provides information useful in making decisions. Thus, one account may be set up for all cash rather than having a separate account for each form of cash (coins on hand, currency on hand, and deposits in banks). The amount of cash is useful information; the form of cash often is not.

To illustrate recording the increases and decreases in an account, texts use the T-account, which looks like a capital letter T. The name of the account, such as Cash, appears across the top of the T. We record increases on one side of the vertical line of the T and decreases on the other side. A T-account appears as follows:

An accounting perspective: Business insight

Have you ever considered starting your own business? If so, you will need to understand accounting to successfully run your business. To know how well your business is doing, you must understand and analyze financial statements. Accounting information also tells you why you are performing as reported. If you are in business to sell or develop a certain product or perform a specific service, you cannot operate profitably or consider expanding unless you base your business decisions on accounting information.

Exhibit 5: The steps in recording and posting the effects of a business transaction

In Chapter 1, you saw that each business transaction affects at least two items. For example, if you - an owner - invest cash in your business, the company's assets increase and its stockholders' equity increases. This result was illustrated in the summary of transactions in Exhibit 1.3. In the following sections, we use debits and credits and the double-entry procedure to record the increases and decreases caused by business transactions.

Accountants use the term debit instead of saying, "Place an entry on the left side of the T-account". They use the term credit for "Place an entry on the right side of the T-account". Debit (abbreviated Dr.) simply means left side; credit (abbreviated Cr.) means right side. Thus, for all accounts a debit entry is an entry on the left side, while a credit entry is an entry on the right side.

After recognizing a business event as a business transaction, we analyze it to determine its increase or decrease effects on the assets, liabilities, stockholders' equity items, dividends, revenues, or expenses of the business. Then we translate these increase or decrease effects into debits and credits.

In each business transaction we record, the total dollar amount of debits must equal the total dollar amount of credits. When we debit one account (or accounts) for USD 100, we must credit another account (or accounts) for a total of USD 100. The accounting requirement that each transaction be recorded by an entry that has equal debits and credits is called double-entry procedure, or duality. This double-entry procedure keeps the accounting equation in balance.

The dual recording process produces two sets of accounts - those with debit balances and those with credit balances. The totals of these two groups of accounts must be equal. Then, some assurance exists that the arithmetic part of the transaction recording process has been properly carried out. Now, let us actually record business transactions in T-accounts using debits and credits.

Recording changes in assets, liabilities, and stockholders' equity

While recording business transactions, remember that the foundation of the accounting process is the following basic accounting equation: 

Assets = Liabilities + Stockholders ' Equity

Recording transactions into the T-accounts is easier when you focus on the equal sign in the accounting equation. Assets, which are on the left of the equal sign, increase on the left side of the T- accounts. Liabilities and stockholders' equity, to the right of the equal sign, increase on the right side of the T-accounts. You already know that the left side of the T-account is the debit side and the right side is the credit side. So you should be able to fill in the rest of the rules of increases and decreases by deduction, such as:

To summarize: 

• Assets increase by debits (left side) to the T-account and decrease by credits (right side) to the T- account. 
  
• Liabilities and stockholders' equity decrease by debits (left side) to the T-account and increase by credits (right side) to the T-account.
  

Applying these two rules keeps the accounting equation in balance. Now we apply the debit and credit rules for assets, liabilities, and stockholders' equity to business transactions.

Assume a corporation issues shares of its capital stock for USD 10,000 in transaction 1. (Note the figure in parentheses is the number of the transaction and ties the two sides of the transaction together.) The company records the receipt of USD 10,000 as follows:

This transaction increases the asset, cash, which is recorded on the left side of the Cash account. Then, the transaction increases stockholders' equity, which is recorded on the right side of the Capital Stock account.

Assume the company borrowed USD 5,000 from a bank on a note (transaction 2). A note is an unconditional written promise to pay to another party (the bank) the amount owed either when demanded or at a specified date, usually with interest at a specified rate. The firm records this transaction as follows:

Observe that liabilities, Notes Payable, increase with an entry on the right (credit) side of the account.

Recording changes in revenues and expenses

In Chapter 1, we recorded the revenues and expenses directly in the Retained Earnings account. However, this is not done in practice because of the volume of revenue and expense transactions. Instead, businesses treat the expense accounts as if they were subclassifications of the debit side of the Retained Earnings account, and the revenue accounts as if they were subclassifications of the credit side. Since firms need the amounts of revenues and expenses to prepare the income statement, they keep a separate account for each type of revenue and expense. The recording rules for revenues and expenses are: 

• Record increases in revenues on the right (credit) side of the T-account and decreases on the left (debit) side. The reasoning behind this rule is that revenues increase retained earnings, and increases in retained earnings are recorded on the right side. 
  
• Record increases in expenses on the left (debit) side of the T-account and decreases on the right (credit) side. The reasoning behind this rule is that expenses decrease retained earnings, and decreases in retained earnings are recorded on the left side.
  

To illustrate these rules, assume the same company received USD 1,000 cash from a customer for services rendered (transaction 3). The Cash account, an asset, increases on the left (debit) side of the T- account; and the Service Revenue account, an increase in retained earnings, increases on the right (credit) side.

Now assume this company paid USD 600 in salaries to employees (transaction 4). The Cash account, an asset, decreases on the right (credit) side of the T-account; and the Salaries Expense account, a decrease in retained earnings, increases on the left (debit) side.

Recording changes in dividends

Since dividends decrease retained earnings, increases appear on the left side of the Dividends account and decreases on the right side. Thus, the firm records payment of a USD 2,000 cash dividend (transaction 5) as follows:

At the end of the accounting period, the accountant transfers any balances in the expense, revenue, and Dividends accounts to the Retained Earnings account. This transfer occurs only after the information in the expense and revenue accounts has been used to prepare the income statement. We discuss and illustrate this step in Chapter 4.

To determine the balance of any T-account, total the debits to the account, total the credits to the account, and subtract the smaller sum from the larger. If the sum of the debits exceeds the sum of the credits, the account has a debit balance. For example, the following Cash account uses information from the preceding transactions. The account has a debit balance of USD 13,400, computed as total debits of USD 16,000 less total credits of USD 2,600.

If, on the other hand, the sum of the credits exceeds the sum of the debits, the account has a credit balance. For instance, assume that a company has an Accounts Payable account with a total of USD 10,000 in debits and USD 13,000 in credits. The account has a credit balance of USD 3,000, as shown in the following T-account:

Normal balances Since debits increase asset, expense, and dividend accounts, they normally have debit (or left-side) balances. Conversely, because credits increase liability, capital stock, retained earnings, and revenue accounts, they normally have credit (or right-side) balances. The following chart shows the normal balances of the seven accounts we have used:

At this point, you should memorize the six rules of debit and credit. Later, as you proceed in your study of accounting, the rules will become automatic. Then, you will no longer ask yourself, "Is this increase a debit or credit?"

Asset accounts increase on the debit side, while liability and stockholders' equity accounts increase on the credit side. When the account balances are totaled, they conform to the following independent equations:

Assets = Liabilities + Stockholders' Equity

Debits = Credits

The arrangement of these two formulas gives the first three rules of debit and credit: 

• Increases in asset accounts are debits; decreases are credits. 
  
• Decreases in liability accounts are debits; increases are credits. 
  
• Decreases in stockholders' equity accounts are debits; increases are credits.
  

Exhibit 6: Rules of debit and credit

The debit and credit rules for expense and Dividends accounts and for revenue accounts follow logically if you remember that expenses and dividends are decreases in stockholders' equity and revenues are increases in stockholders' equity. Since stockholders' equity accounts decrease on the debit side, expense and Dividend accounts increase on the debit side. Since stockholders' equity accounts increase on the credit side, revenue accounts increase on the credit side. The last three debit and credit rules are: 

• Decreases in revenue accounts are debits; increases are credits. 
  
• Increases in expense accounts are debits; decreases are credits. 
  
• Increases in Dividends accounts are debits; decreases are credits.
  

The accounting cycle

The accounting cycle is a series of steps performed during the accounting period (some throughout the period and some at the end) to analyze, record, classify, summarize, and report useful financial information for the purpose of preparing financial statements. Before you can visualize the eight steps in the accounting cycle, you must be able to recognize a business transaction. Business transactions are measurable events that affect the financial condition of a business. For example, assume that the owner of a business spilled a pot of coffee in her office or broke her leg while skiing. These two events may briefly interrupt the operation of the business. However, they are not measurable in terms that affect the solvency and profitability of the business.

Business transactions can be the exchange of goods for cash between the business and an external party, such as the sale of a book, or they can involve paying salaries to employees. These events have one fundamental criterion: They must have caused a measurable change in the amounts in the accounting equation, Assets = Liabilities + Stockholders' Equity. The evidence that a business event has occurred is a source document such as a sales ticket, check, and so on. Source documents are important because they are the ultimate proof of business transactions.

After you have determined that an event is a measurable business transaction and have adequate proof of this transaction, mentally analyze the transaction's effects on the accounting equation. You learned how to do this in Chapter 1. This chapter and Chapters 3 and 4 describe the other steps in the accounting cycle. The eight steps in the accounting cycle and the chapters that discuss them are: 

• Analyze transactions by examining source documents
  
• Journalize transactions in the journal
• Post journal entries to the accounts in the ledger
  
• Prepare a trial balance of the accounts
•  and complete the work sheet
• Prepare financial statements
• Journalize and post adjusting entries
  
• Journalize and post closing entries
• Prepare a post-closing trial balance

Notice that firms perform the last five steps at the end of the accounting period. Step 5 precedes steps 6 and 7 because management needs the financial statements at the earliest possible date. After the statements have been delivered to management, the adjusting and closing entries can be journalized and posted. In Exhibit 7, we diagram the eight steps in the accounting cycle.

You can perform many of these steps on a computer with an accounting software package. However, you must understand a manual accounting system and all of the steps in the accounting cycle to understand what the computer is doing. This understanding removes the mystery of what the computer is doing when it takes in raw data and produces financial statements

The journal

In explaining the rules of debit and credit, we recorded transactions directly in the accounts. Each ledger (general ledger) account shows only the increases and decreases in that account. Thus, all the effects of a single business transaction would not appear in any one account. For example, the Cash account contains only data on changes in cash and does not show how the cash was generated or how it was spent. To have a permanent record of an entire transaction, the accountant uses a book or record known as a journal.

A journal is a chronological (arranged in order of time) record of business transactions. A journal entry is the recording of a business transaction in the journal. A journal entry shows all the effects of a business transaction as expressed in debit(s) and credit(s) and may include an explanation of the transaction. A transaction is entered in a journal before it is entered in ledger accounts. Because each transaction is initially recorded in a journal rather than directly in the ledger, a journal is called a book of original entry.

A business usually has more than one journal. Chapter 4 briefly describes several special journals. In this chapter, we use the basic form of journal, the general journal. As shown in Exhibit 8, a general journal contains the following columns:

Exhibit 7: Steps in the accounting cycle 

Exhibit 8: Journal entry 

Date column. The first column on each journal page is for the date. For the first journal entry on a page, this column contains the year, month, and day (number). For all other journal entries on a page, this column contains only the day of the month, until the month changes. 

Account titles and explanation column. The first line of an entry shows the account debited. The second line shows the account credited. Notice that we indent the credit account title to the right. For instance, in Exhibit 8 we show the debit to the Cash account and then the credit to the Capital Stock account. Any necessary explanation of a transaction appears on the line(s) below the credit entry and is indented halfway between the accounts debited and credited. A journal entry explanation should be concise and yet complete enough to describe fully the transaction and prove the entry's accuracy. When a journal entry is self-explanatory, we omit the explanation. 

Posting reference column. This column shows the account number of the debited or credited account. For instance, in Exhibit 8, the number 100 in the first entry means that the Cash account number is 100. No number appears in this column until the information has been posted to the appropriate ledger account. We discuss posting later in the chapter. 

Debit column. In the debit column, the amount of the debit is on the same line as the title of the account debited. 

Credit column. In the credit column, the amount of the credit is on the same line as the title of the account credited.

An account perspective: Uses of technology Preparing journal entries in a computerized system is different than in a manual system. The computer normally asks for the number of the account to be debited. After you type the account number, the computer shows the account title in its proper position. The cursor then moves to the debit column and waits for you to enter the amount of the debit. Then it asks if there are more debits. If not, the computer prompts you for the account number of the credit. After you type the account number, the computer supplies the account name of the credit and enters the same amount debited as the credit. When there is more than one credit, you can override the amount and enter the correct amount. Then you would enter the other credit in the same way. If your debits and credits are not equal, the computer warns you and makes you correct the error. You can supply an explanation for the entry from a standard list or type it in. As you enter the journal entries, the computer automatically posts them to the ledger accounts. At any time, you can have the computer print a trial balance.

A summary of the functions and advantages of using a journal follows:

The journal -

• Records transactions in chronological order. 
  
• Shows the analysis of each transaction in debits and credits. 
  
• Supplies an explanation of each transaction when necessary. 
  
• Serves as a source for future reference to accounting transactions. 
  
• Eliminates the need for lengthy explanations from the accounts. 
  
• Makes possible posting to the ledger at convenient times. 
  
• Assists in maintaining the ledger in balance because the debit(s) must always equal the credit(s) in each journal entry. 
  
• Aids in tracing errors when the ledger is not in balance.
  

The ledger

A ledger (general ledger) is the complete collection of all the accounts of a company. The ledger may be in loose-leaf form, in a bound volume, or in computer memory.

Accounts fall into two general groups: (1) balance sheet accounts (assets, liabilities, and stockholders' equity) and (2) income statement accounts (revenues and expenses). The terms real accounts and permanent accounts also refer to balance sheet accounts. Balance sheet accounts are real accounts because they are not subclassifications or subdivisions of any other account. They are permanent accounts because their balances are not transferred (or closed) to any other account at the end of the accounting period. Income statement accounts and the Dividends account are nominal accounts because they are merely subclassifications of the stockholders' equity accounts. Nominal literally means "in name only". Nominal accounts are also called temporary accounts because they temporarily contain revenue, expense, and dividend information that is transferred (or closed) to the Retained Earnings account at the end of the accounting period.

The chart of accounts is a complete listing of the titles and numbers of all the accounts in the ledger. The chart of accounts can be compared to a table of contents. The groups of accounts usually appear in this order: assets, liabilities, stockholders' equity, dividends, revenues, and expenses.

Individual accounts are in sequence in the ledger. Each account typically has an identification number and a title to help locate accounts when recording data. For example, a company might number asset accounts, 100-199; liability accounts, 200-299; stockholders' equity accounts and Dividends account, 300-399; revenue accounts, 400-499; and expense accounts, 500-599. We use this numbering system in this text. The uniform chart of accounts used in the first 11 chapters appears in a separate file at the end of the text. You should print that file and keep it handy for working certain problems and exercises. Companies may use other numbering systems. For instance, sometimes a company numbers its accounts in sequence starting with 1, 2, and so on. The important idea is that companies use some numbering system.

Now that you understand how to record debits and credits in an account and how all accounts together form a ledger, you are ready to study the accounting process in operation.

The accounting process in operation

MicroTrain Company is a small corporation that provides on-site personal computer software training using the clients' equipment. The company offers beginning through advanced training with convenient scheduling. A small fleet of trucks transports personnel and teaching supplies to the clients' sites. The company rents a building and is responsible for paying the utilities.

We illustrate the capital stock transaction that occurred to form the company (in November) and the first month of operations (December). The accounting process used by this company is similar to that of any small company. The ledger accounts used by MicroTrain Company are:

Notice the gaps left between account numbers (100, 103, 107, etc.). These gaps allow the firm to later add new accounts between the existing accounts.

To begin, a transaction must be journalized. Journalizing is the process of entering the effects of a transaction in a journal. Then, the information is transferred, or posted, to the proper accounts in the ledger. Posting is the process of recording in the ledger accounts the information contained in the journal. We explain posting in more detail later in the chapter.

In the following example, notice that each business transaction affects two or more accounts in the ledger. Also note that the transaction date in both the general journal and the general ledger accounts is the same. In the ledger accounts, the date used is the date that the transaction was recorded in the general journal, even if the entry is not posted until several days later. Our example shows the journal entries posted to T-accounts. In practice, firms post journal entries to ledger accounts, as we show later in the chapter.

Accountants use the accrual basis of accounting. Under the accrual basis of accounting, they recognize revenues when the company makes a sale or performs a service, regardless of when the company receives the cash. They recognize expenses as incurred, whether or not the company has paid out cash. Chapter 3 discusses the accrual basis of accounting in more detail.

In the following MicroTrain Company example, transaction 1 increases (debits) Cash and increases (credits) Capital Stock by USD 50,000. First, MicroTrain records the transaction in the general journal; second, it posts the entry to the accounts in the general ledger.

Transaction 1: 2010 Nov. 28 Stockholders invested $50,000 and formed MicroTrain Company.

No other transactions occurred in November. The company prepares financial statements at the end of each month. Exhibit 9 shows the company's balance sheet at 2010 November 30. The balance sheet reflects ledger account balances as of the close of business on 2010 November 30. These closing balances are the beginning balances on 2010 December 1. The ledger accounts show these closing balances as beginning balances.

Now assume that in December 2010, MicroTrain Company engaged in the following transactions. We show the proper recording of each transaction in the journal and then in the ledger accounts (in T- account form), and describe the effects of each transaction. 

Exhibit 9: Balance sheet

Transaction 2: Dec. 1 Paid cash for four small trucks, $40,000.

Transaction 3: Dec. 1 Paid cash for insurance on the trucks to cover a one-year period from this date.

Effects of transaction

An asset, prepaid insurance, increases (debited); and an asset, cash, decreases (credited) by USD 2,400. The debit is to Prepaid Insurance rather than Insurance Expense because the policy covers more than the current accounting period of December (insurance policies are usually paid one year in advance). As you will see in Chapter 3, prepaid items are expensed as they are used. If this insurance policy was only written for December, the entire USD 2,400 debit would have been to Insurance Expense.

Transaction 4: Dec. 1 Rented a building and paid $1,200 to cover a three-month period from this date.

Effects of transaction

An asset, prepaid rent, increases (debited); and another asset, cash, decreases (credited) by USD 1,200. The debit is to Prepaid Rent rather than Rent Expense because the payment covers more than the current month. If the payment had just been for December, the debit would have been to Rent Expense.

Transaction 5: Dec. 4 Purchased $1,400 of training supplies on account to be used over the next several months.

Effects of transaction 

An asset, supplies on hand, increases (debited); and a liability, accounts payable, increases (credited) by USD 1,400. The debit is to Supplies on Hand rather than Supplies Expense because the supplies are to be used over several accounting periods.

In each of the three preceding entries, we debited an asset rather than an expense. The reason is that the expenditure applies to (or benefits) more than just the current accounting period. Whenever a company will not fully use up an item such as insurance, rent, or supplies in the period when purchased, it usually debits an asset. In practice, however, sometimes the expense is initially debited in these situations.

Companies sometimes buy items that they fully use up within the current accounting period. For example, during the first part of the month a company may buy supplies that it intends to consume fully during that month. If the company fully consumes the supplies during the period of purchase, the best practice is to debit Supplies Expense at the time of purchase rather than Supplies on Hand. This same advice applies to insurance and rent. If a company purchases insurance that it fully consumes during the current period, the company should debit Insurance Expense at the time of purchase rather than Prepaid Insurance. Also, if a company pays rent that applies only to the current period, Rent Expense should be debited at the time of purchase rather than Prepaid Rent. As illustrated in Chapter 3, following this advice simplifies the procedures at the end of the accounting period.

Transaction 6: Dec. 7 Received $4,500 from a customer in payment for future training services.

Effects of transaction

An asset, cash, increases (debited); and a liability, unearned service revenue, increases (credited) by USD 4,500. The credit is to Unearned Service Fees rather than Service Revenue because the USD 4,500 applies to more than just the current accounting period. Unearned Service Fees is a liability because, if the services are never performed, the USD 4,500 will have to be refunded. If the payment had been for services to be provided in December, the credit would have been to Service Revenue.

Transaction 7: Dec. 15 Performed training services for a customer for cash, $5,000.

Effects of transaction

An asset, cash, increases (debited); and a revenue, service revenue, increases (credited) by USD 5,000.

Transaction 8: Dec. 17 Paid the $1,400 account payable resulting from the transaction of December 4.

Effects of transaction

A liability, accounts payable, decreases (debited); and an asset, cash, decreases (credited) by USD 1,400.

Transaction 9: Dec. 20 Billed a customer for training services performed, $5,700.

Effects of transaction

An asset, accounts receivable, increases (debited); and a revenue, service revenue, increases (credited) by USD 5,700.

Effects of transaction

An expense, advertising expense, increases (debited); and a liability, accounts payable, increases (credited) by USD 50. The reason for debiting an expense rather than an asset is because all the cost pertains to the current accounting period, the month of December. Otherwise, Prepaid Advertising (an asset) would have been debited.

Transaction 11: Dec. 26 Received $500 on accounts receivable from a customer. 

Effects of transaction One asset, cash, increases (debited); and another asset, accounts receivable, decreases (credited) by USD 500.

Transaction 12: Dec. 28 Paid salaries of $3,600 to training personnel for the first four weeks of December. (Payroll and other deductions are to be ignored since they have not yet been discussed).

Effects of transaction

An expense, salaries expense, increases (debited); and an asset, cash, decreases (credited) by USD 3,600.

Transaction 13: Dec. 29 Received and paid the utilities bill for December, $150.

Effects of transaction

An expense, utilities expense, increases (debited); and an asset, cash, decreases (credited) by USD 150.

Transaction 14: Dec. 30 Received a bill for gas and oil used in the trucks for December, $680.

Effects of transaction

An expense, gas and oil expense, increases (debited); and a liability, accounts payable, increases (credited) by USD 680.

Transaction 15: Dec. 31 A dividend of $3,000 was paid to stockholders.

Effects of transaction

The Dividends account increases (debited); and an asset, cash, decreases (credited) by USD 3,000. Transaction 15 concludes the analysis of the MicroTrain Company transactions. The next section discusses and illustrates posting to ledger accounts and cross-indexing.

An accounting perspective: Uses of technology

The concept of the Internet dates to the 1960s when the military tied together several computers forming a "network" that allowed users to communicate with each other instantaneously on their computers over many miles. Then universities and scientific institutions connected to the network to meet their research and communication needs. More and more organizations hooked up to the network over time. Today many companies seek customers and employees over the Internet. Students and faculty use the Internet to perform research, communicate with their colleagues (using e-mail), and search distant libraries. Accountants in practice are heavy users of the Internet to locate company data, tax regulations, and almost any other information they need. You will find that learning to use the Internet effectively is essential to your future success.

The use of ledger accounts

A journal entry is like a set of instructions. The carrying out of these instructions is known as posting. As stated earlier, posting is recording in the ledger accounts the information contained in the journal. A journal entry directs the entry of a certain dollar amount as a debit in a specific ledger account and directs the entry of a certain dollar amount as a credit in a specific ledger account. Earlier, we posted the journal entries for MicroTrain Company to T-accounts. In practice, however, companies post these journal entries to ledger accounts.

Using a new example, Jenks Company, we illustrate posting to ledger accounts. Later, we show you how to post the MicroTrain Company journal entries to ledger accounts.

In Exhibit 10, the first journal entry for the Jenks Company directs that USD 10,000 be posted in the ledger as a debit to the Cash account and as a credit to the Capital Stock account. We post the debit in the general ledger Cash account by using the following procedure: Enter in the Cash account the date, a short explanation, the journal designation ("G" for general journal) and the journal page number from which the debit is posted, and the USD 10,000 in the Debit column. Then, enter the number of the account to which the debit is posted in the Posting Reference column of the general journal. Post the credit in a similar manner but as a credit to Account No. 300. The arrows in Exhibit 10 show how these amounts were posted to the correct accounts.

Exhibit 10 shows the ledger account. In contrast to the two-sided T-account format shown so far, the three-column format has columns for debit, credit, and balance. The three-column form has the advantage of showing the balance of the account after each item has been posted. In addition, in this chapter, we indicate whether each balance is a debit or a credit. In later chapters and in practice, the nature of the balance is usually not indicated since it is understood. Also, notice that we give an explanation for each item in the ledger accounts. Often accountants omit these explanations because each item can be traced back to the general journal for the explanation.

Posting is always from the journal to the ledger accounts. Postings can be made (1) at the time the transaction is journalized; (2) at the end of the day, week, or month; or (3) as each journal page is filled. The choice is a matter of personal taste. When posting the general journal, the date used in the ledger accounts is the date the transaction was recorded in the journal, not the date the journal entry was posted to the ledger accounts.

Frequently, accountants must check and trace the origin of their transactions, so they provide cross- indexing. Cross-indexing is the placing of (1) the account number of the ledger account in the general journal and (2) the general journal page number in the ledger account. As shown in Exhibit 10, the account number of the ledger account to which the posting was made is in the Posting Reference column of the general journal. Note the arrow from Account No. 100 in the ledger to the 100 in the Posting Reference column beside the first debit in the general journal. Accountants place the number of the general journal page from which the entry was posted in the Posting Reference column of the ledger account. Note the arrow from page 1 in Exhibit 10 the general journal to G1 in the Posting Reference column of the Cash account in the general ledger. The notation "G1" means general journal, page 1. The date of the transaction also appears in the general ledger. Note the arrows from the date in the general journal to the dates in the general ledger.

Exhibit 10: General journal and general ledger; posting and cross-indexing

Cross-indexing aids the tracing of any recorded transaction, either from general journal to general ledger or from general ledger to general journal. Normally, they place cross-reference numbers in the Posting Reference column of the general journal when the entry is posted. If this practice is followed, the cross-reference numbers indicate that the entry has been posted.

MICROTRAIN COMPANY
General Journal

Exhibit 11: General journal (after posting)

To understand the posting and cross-indexing process, trace the entries from the general journal to the general ledger. The ledger accounts need not contain explanations of all the entries, since any needed explanations can be obtained from the general journal.

Look at Exhibit 11 to see how all the November and December transactions of MicroTrain Company would be journalized. As shown in Exhibit 11, you skip a line between journal entries to show where one journal entry ends and another begins. This procedure is standard practice among accountants. Note that no dollar signs appear in journals or ledgers. When amounts are in even dollar amounts, accountants leave the cents column blank or use zeros or a dash. When they use lined accounting work papers, commas or decimal points are not needed to record an amount. When they use unlined paper, they add both commas and decimal points.

Next, observe Exhibit 12, the three-column general ledger accounts of MicroTrain Company after the journal entries have been posted. Each ledger account would appear on a separate page in the ledger. Trace the postings from the general journal to the general ledger to make sure you know how to post journal entries.

All the journal entries illustrated so far have involved one debit and one credit; these journal entries are called simple journal entries. Many business transactions, however, affect more than two accounts. The journal entry for these transactions involves more than one debit and/or credit. Such journal entries are called compound journal entries.

As an illustration of a compound journal entry, assume that on 2011 January 2, MicroTrain Company purchased USD 8,000 of training equipment from Wilson Company. See below.

MICROTRAIN COMPANY
General Ledger
Cash

Exhibit 12: General ledger - Extended illustration

MICROTRAIN COMPANY
Trial Balance
December 31, 2010

Exhibit 13: Trial balance

MicroTrain paid USD 2,000 cash with the balance due on 2011 March 3. The general journal entry for MicroTrain Company is:

Note that the firm credits two accounts, Cash and Accounts Payable, in this one entry. However, the dollar totals of the debits and credits are equal.

Periodically, accountants use a trial balance to test the equality of their debits and credits. A trial balance is a listing of the ledger accounts and their debit or credit balances to determine that debits equal credits in the recording process. The accounts appear in this order: assets, liabilities, stockholders' equity, dividends, revenues, and expenses. Within the assets category, the most liquid (closest to becoming cash) asset appears first and the least liquid appears last. Within the liabilities, those liabilities with the shortest maturities appear first. Study Exhibit 13, the trial balance for MicroTrain Company. Note the listing of the account numbers and account titles on the left, the column for debit balances, the column for credit balances, and the equality of the two totals.

When the trial balance does not balance, try re-totaling the two columns. If this step does not locate the error, divide the difference in the totals by 2 and then by 9. If the difference is divisible by 2, you may have transferred a debit-balanced account to the trial balance as a credit, or a credit-balanced account as a debit. When the difference is divisible by 2, look for an amount in the trial balance that is equal to one-half of the difference. Thus, if the difference is USD 800, look for an account with a balance of USD 400 and see if it is in the wrong column.

If the difference is divisible by 9, you may have made a transposition error in transferring a balance to the trial balance or a slide error. A transposition error occurs when two digits are reversed in an amount (e.g. writing 753 as 573 or 110 as 101). A slide error occurs when you place a decimal point incorrectly (e.g. USD 1,500 recorded as USD 15.00). Thus, when a difference is divisible by 9, compare the trial balance amounts with the general ledger account balances to see if you made a transposition or slide error in transferring the amounts.

An ethical perspective: Financial Deals, Inc.

Larry Fisher was captain of the football team at Prestige University. Later, he earned a master's degree in business administration with a concentration in accounting. Upon graduation, Larry accepted a position with Financial Deals, Inc., in the accounting and finance division. At first, things were going smoothly. He was tall, good looking, and had an outgoing personality. The president of the company took a liking to him. However, Larry was somewhat bothered when the president started asking him to do some things that were slightly unethical. When he protested mildly, the president said: "Come on, son, this is the way the business world works. You have great potential if you don't let things like this get in your way".

As time went on, Larry was asked to do things that were more unethical, and finally he was performing illegal acts. When he resisted, the president appealed to his loyalty and asked him to be a team player. The president also promised Larry great wealth sometime in the future. Finally, when he was told to falsify some financial statements by making improper entries and to sign some documents containing material errors, the president supported his request by stating: "You are in too deep now to refuse to cooperate. If I go down, you are going with me". Through various company schemes, Larry had convinced some friends and relatives to invest about USD 10 million. Most of this would be lost if the various company schemes were revealed.

Larry could not sleep at night and began each day with a pain in his stomach and by becoming physically ill. He was under great strain and believed that he could lose his mind. He also heard that the president had a shady past and could become violent in retaliating against his enemies. If Larry blows the whistle, he believes he will go to prison for his part in the schemes. (Note: This scenario is based on an actual situation with some facts changed to protect the guilty).

If you still cannot find the error, it may be due to one of the following causes: 

• Failing to post part of a journal entry. 
  
• Posting a debit as a credit, or vice versa. 
  
• Incorrectly determining the balance of an account. 
  
• Recording the balance of an account incorrectly in the trial balance. 
  
• Omitting an account from the trial balance.
  
• Making a transposition or slide error in the accounts or the journal.
  

Usually, you should work backward through the steps taken to prepare the trial balance. Assuming you have already re-totaled the columns and traced the amounts appearing in the trial balance back to the general ledger account balances, use the following steps: Verify the balance of each general ledger account, verify postings to the general ledger, verify general journal entries, and then review the transactions and possibly the source documents.

The equality of the two totals in the trial balance does not necessarily mean that the accounting process has been error-free. Serious errors may have been made, such as failure to record a transaction, or posting a debit or credit to the wrong account. For instance, if a transaction involving payment of a USD 100 account payable is never recorded, the trial balance totals still balance, but at an amount that is USD 100 too high. Both cash and accounts payable would be overstated by USD 100. You can prepare a trial balance at any time - at the end of a day, a week, a month, a quarter, or a year. Typically, you would prepare a trial balance before preparing the financial statements.

An accounting perspective: Uses of technology

The computers of persons in a given department or building are frequently connected in a Local Area Network (LAN). These persons can then access simultaneously the programs and databases stored in the LAN and can communicate with all other persons in the LAN through email. A more advanced type of computer network is called Client/Server Computing. Under this structure, any computer in the network can be used to update the information stored elsewhere in the network. For example, accounting information stored in one computer could be updated by authorized persons from a number of other computers in the system. The use of networks is designed to improve efficiency and to reduce software and hardware costs.

Analyzing and using the financial results - Horizontal and vertical analyses

The calculation of dollar and/or percentage changes from one year to the next in an item on financial statements is horizontal analysis. For instance, in the following data taken from the 2000 annual report of Hewlett-Packard Company, the amount of inventory increased by USD 836 million from 1999 October 31, to 2000 October 31. This amount represented a 17 per cent increase. To find the amount of the increase or decrease, subtract the 1999 amount from the 2000 amount. To find the percentage change, divide the increase or decrease by the 1999 amount.

Knowing the dollar amount and percentage of change in an amount is much more meaningful than merely knowing the amount at one point in time. By analyzing the data, we can see that cash and cash equivalents declined in 2000. Their decline at least partially explains the increases in some of the other current assets. We can also see that the company invested in property, plant and equipment. Any terms in Hewlett-Packard's list of assets that you do not understand are explained in later chapters. At this point, all we want you to understand is the nature of horizontal and vertical analyses.

Vertical analysis shows the percentage that each item in a financial statement is of some significant total such as total assets or sales. For instance, in the Hewlett-Packard data we can see that cash and cash equivalents were 15.3 per cent of total assets as of 1999 October 31, and had declined to 10.0 per cent of total assets by 2000 October 31. Total current assets (cash plus other amounts that will become cash or be used up within one year) increased from 61.3 per cent of total assets to 68.3 per cent during 2000. Long-term investments and other non-current assets accounted for 18.4 per cent of total assets as of 2000 October 31.

Management performs horizontal and vertical analyses along with other forms of analysis to help evaluate the wisdom of its past decisions and to plan for the future. Other data would have to be examined before decisions could be made regarding the assets shown. For instance, if you discovered the liabilities that would have to be paid within a short time by Hewlett-Packard were more than USD 30 billion, you might conclude that the company is short of cash even though current assets increased substantially during 2000. We illustrate horizontal and vertical analyses to a much greater extent later in the text.

An accounting perspective: Business insight

Many companies have been restructuring their organizations and reducing the number of employees to cut expenses. General Motors, AT&T, IBM, and numerous other companies have taken this action. One could question whether companies place as much value on their employees as in the past. In previous years it was common to see the following statement in the annual reports of companies: "Our employees are our most valuable asset". Companies are not permitted to show employees as assets on their balance sheets. Do you think they should be allowed to do so?

What you have learned in this chapter is basic to your study of accounting. The entire process of accounting is based on the double-entry concept. Chapter 3 explains that adjustments bring the accounts to their proper balances before accurate financial statements are prepared.

Understanding the learning objectives 

• An account is a storage unit used to classify and summarize money measurements of business activities of a similar nature. 
  
• A firm sets up an account whenever it needs to provide useful information about a particular business item to some party having a valid interest in the business. 
  
• A T-account resembles the letter T. 
  
• Debits are entries on the left side of a T-account. 
  
• Credits are entries on the right side of a T-account. 
  
• Debits increase asset, expense, and Dividends accounts. 
  
• Credits increase liability, stockholders' equity, and revenue accounts. 
  
• Analyze transactions by examining source documents. 
• Journalize transactions in the journal. 
  
• Post journal entries to the accounts in the ledger. 
  
• Prepare a trial balance of the accounts and complete the work sheet. 
  
• Prepare financial statements.
  
• Journalize and post adjusting entries. 
  
• Journalize and post closing entries. Prepare a post-closing trial balance. 
  
• A journal contains a chronological record of the transactions of a business. An example of a general journal is shown in Exhibit 11. Journalizing is the process of entering a transaction in a journal. 
  
• Posting is the process of transferring information recorded in the journal to the proper places in the ledger. 
  
• Cross-indexing is the placing of (1) the account number of the ledger account in the general journal and (2) the general journal page number in the ledger account. 
  
• An example of cross-indexing appears in Exhibit 10. 
  
• A trial balance is a listing of the ledger accounts and their debit or credit balances. 
  
• If the trial balance does not balance, an accountant works backward to discover the error. 
  
• A trial balance is shown in Exhibit 13. 
  
• Horizontal analysis involves calculating the dollar and/or percentage changes in an item from one year to the next. 
  
• Vertical analysis shows the percentage that each item in a financial statement is of some significant total.