BUS103: Introduction to Financial Accounting

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.