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Chapter 4 Chapter 4
Keeping the Books: Keeping the Books:
The Mechanics of an The Mechanics of an Accounting SystemAccounting System
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The Traditional Way to The Traditional Way to Keep the Books:Keep the Books:The General Ledger SystemThe General Ledger System
THE ACCOUNTING CYCLE: Transactions occur in the normal course of
business. We record them in our records with a JOURNAL ENTRY.
Journal entries are posted to the GENERAL LEDGER.
ADJUSTING ENTRIES are made and posted.
Transactions
Financial Statements
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Accounting cycle continued...Accounting cycle continued...
A trial balance can be prepared at any time to make sure we haven’t made an error with the debit-credit part of the accounting system. More about that after we learn the nuts and bolts about DEBITS and CREDITS...
Financial statements are written. Closing journal entries are made and
posted (and a post-closing trial balance
may be prepared).
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TerminologyTerminology
What’s a general ledger? A big book of accounting records in which
every page is an “account.” What’s an account?
A page in the general ledger that is devoted to keeping track of an individual asset or liability or type of owners’ equity.
How many are there? As many as the business find necessary for its record keeping.
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Accounts…debits and creditsAccounts…debits and credits
Each account can be increased or decreased.
For example, CASH can be increased (when it is collected) and decreased (when it is disbursed).
Each item on the balance sheet is either an account or a composite of several accounts.
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How this debit/credit stuff works:How this debit/credit stuff works:DEBITDEBIT means means LEFTLEFT side sideCREDITCREDIT means means RIGHTRIGHT side side
We can represent an account with a TT, where one side is the place where we put the increasesand the other side is for decreases.
The left side is always called the debit side.When we put something on the left side of an account, we are debiting the account.The right side is always called the credit side. When we put something on the right side of an account,we are crediting the account.
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How this Debit/Credit Stuff WorksHow this Debit/Credit Stuff Works
Assets= Liabilities + Owners’ Equity
Revenue Expense
++
Increases in assets go on the left.
Debits increase assetsDebits increase assets..
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Assets= Liabilities + Owners’ Equity
Revenue Expense
++ ____
How this Debit/Credit Stuff WorksHow this Debit/Credit Stuff Works
Decreases in assets go on the right.
Credits decrease assets.Credits decrease assets.
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Assets= Liabilities + Owners’ Equity
Revenue Expense
++ ____
How this Debit/Credit Stuff WorksHow this Debit/Credit Stuff Works
Increases in liabilities go on the right.
Credits increase liabilities.Credits increase liabilities.
++
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Assets= Liabilities + Owners’ Equity
Revenue Expense
++ ____
How this Debit/Credit Stuff WorksHow this Debit/Credit Stuff Works
Decreases in liabilities go on the left
Debits decrease liabilities.Debits decrease liabilities.
++____
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Owner’s Equity AccountsOwner’s Equity Accounts
Contributed Capital and Retained Contributed Capital and Retained Earnings) are increased with credits and Earnings) are increased with credits and decreased with debits.decreased with debits.
Assets= Liabilities + Owners’ Equity
Revenue Expense++ __
++__ ++____
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Revenue and Expense AccountsRevenue and Expense Accounts
Revenue and expense accounts are Revenue and expense accounts are not considered “owners’ equity” not considered “owners’ equity” accounts--even though they accounts--even though they effectively increase or decrease effectively increase or decrease equity!equity!
They are called They are called income statement income statement accounts,accounts, often called temporary or often called temporary or nominal accounts.nominal accounts.
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Revenue AccountsRevenue Accounts
An increase in a revenue causes an An increase in a revenue causes an increase in owners’ equity--so the increase in owners’ equity--so the debits and credits will be the same debits and credits will be the same for revenue accounts as they are for for revenue accounts as they are for owners’ equity:owners’ equity: Credits increase Credits increase revenue accounts and debits revenue accounts and debits decrease revenue accounts.decrease revenue accounts.
Revenue accounts keep track of all the Revenue accounts keep track of all the company’s earnings from sales and services.company’s earnings from sales and services.
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Revenues are Revenues are increased with creditsincreased with credits and and decreased with debitsdecreased with debits..
Assets= Liabilities + Owners’ Equity
Revenue Expense++ __
++__ ++____
++____
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Expenses reduce owners’ equity, so Expenses reduce owners’ equity, so the debits and credits are opposite of the debits and credits are opposite of those for the OE accounts:those for the OE accounts:debits increase expenses, debits increase expenses, credits decrease expenses.credits decrease expenses.
Assets= Liabilities + Owners’ Equity
Revenue Expense++ __
++__ ++____
++ ++________
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SUMMARY:SUMMARY:DOUBLE-ENTRY ACCOUNTINGDOUBLE-ENTRY ACCOUNTING
Each account can be increased or decreased. Debit means “left side” Credit means “right side” Asset and expense accounts are increased
with debits and decreased with credits. Liability, equity, and revenue accounts are
increased with credits and decreased with debits.
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T-AccountsT-Accounts
+ Increase
ASSETS • In a transaction that
increases an asset, put that amount on the left.
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T-AccountsT-Accounts
+ Increase
ASSETS
- Decrease
• In a transaction that increases an asset, put that amount on the left.
• In a transaction that decreases an asset, put that amount on the right.
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T-AccountsT-Accounts
+ Increase
ASSETS
- Decrease • In a transaction that
increases an asset, put that amount on the left.
• In a transaction that decreases an asset, put that amount on the right.
In our accounting records, we never cross out or subtract or change a number. Instead, we use debits and credits to change the balance in an account.
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T-AccountsT-Accounts
+ Increase
ASSETS
- Decrease • In a transaction that
increases an asset, put that amount on the left.
• In a transaction that decreases an asset, put that amount on the right.
Calculate the balance in an asset accountat any time by adding the amounts on the left and subtracting the amounts on the right.
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T-Accounts: AssetsT-Accounts: Assets
CASHCASH
debitsincreaseassets
e.g., when we receive cash, we debit the CASH account
DEBITS
on the
left!!
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T-Accounts: AssetsT-Accounts: Assets
CASHCASH
debitsIncrease assets
creditsdecreaseassets
e.g., when wereceive cash,we debit the CASH account
Credits
on the
right!!
e.g., when we disburse cash, we credit theCASH account
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T-Accounts: Liabilities and EquityT-Accounts: Liabilities and Equity
Accounts PayableAccounts Payable
debits liabilities
credits liabilities
e.g., when we pay off some of our accounts payable
Credits
on the
right!!
Debits
on the
left!!
e.g., when we record an amount we owe someone
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T-AccountsT-Accounts
LIABILITIES
+ Increase-Decrease EQUITY
-Decrease + Increase
Additions to theseaccounts are put on the right.
Deductions from theseaccounts are put on the left.
Equity accounts work like liability accounts:
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What about What about Revenue and Expense Accounts?Revenue and Expense Accounts?
Since revenuesrevenues increase owners’ equity, they are increased with credits---just like owners’ equity accounts.
Service Revenue
+
Revenue accountsare rarely debited..
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Since expensesexpenses decrease owners’ equity, they are increased with debits---just the opposite of owners’ equity accounts.
Expenses
+
Expense accountsare rarely credited.
What about What about Revenue and Expense Accounts?Revenue and Expense Accounts?
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Since expensesexpenses decrease owners’ equity, they are increased with debits---just the opposite of owners’ equity accounts.
Expenses
+
Expense accountsare rarely credited..
Remember, an expense account is simply a list of the company’s expenses. So as we incur expenses, we increase the expense account. That is, we are adding to our list of expenses.
What about What about Revenue and Expense Accounts?Revenue and Expense Accounts?
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What is a journal and a journal entry?What is a journal and a journal entry?
A journal is a book where a chronological record of transactions is recorded.
Only basic information is contained in the journal.
A “journal entry” is just a recorded transaction. Because of the design of the debit/credit
system to go with the accounting equation, in every journal entry there are equal dollar amounts of debits and credits.
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Journal entries are recorded chronologically as the transactions occur:
e.g., Services are rendered for $100 cash:
Cash 100
Service Revenue 100
An explanation goes here.
Journal entries are written in a journal and then posted to the general ledger accounts (our t-accounts)
How do journal entries How do journal entries relate to T-Accounts?relate to T-Accounts?
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They are then posted to the They are then posted to the General Ledger (our t-accounts)General Ledger (our t-accounts)
CASH
SALES
100
100
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Assets Liabilities
+ increase - decrease - decrease + increase
Owners’ Equity
-decrease + increase
Summary of Debits and CreditsSummary of Debits and Credits
Revenues
Expenses
++
++
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Summary of Journal EntriesSummary of Journal Entries
Assets and Expenses are increased with debits.
Assets include Cash A/R Inventory Supplies Prepaid Rent Equipment
Liabilities and Owners’ Equity and Revenue accounts are increased with credits.
Liabilities include all PAYABLES.
Equity accounts include: Contributed Capital Retained Earnings
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ABC Company received $4,000 from a client for services to be performed at a future date.
Cash Unearned Revenue
Example IExample I
$4000 $4000
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ABC Company paid $1,500 to employees for work completed.
1,500 1,500
Example IIExample II
Cash Salary Expense
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ABC Company paid $3,000 for a new piece of office equipment.
$3,000
Cash Equipment
$3000
Example IIIExample III
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Recognized one-fourth of the $4,000 unearned revenue (received in a previous transaction) because one-fourth of the work was completed.
* previously recorded
Example IVExample IV
Unearned Revenue Revenue
1000 4000* 1000
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Trial Balance: a list of each account Trial Balance: a list of each account and its debit or credit balance.and its debit or credit balance.
Since debits = credits in all journal entries, at any point in time we should be able to take the balances in all of our general ledger accounts and confirm that DEBITS = CREDITS for all accounts together.
debits credits
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Adjusting EntriesAdjusting Entries
Before financial statements are prepared, adjusting entries must be recorded to make sure that all accounts are properly stated and that nothing has been omitted.
Adjustments need to be made for Accruals Deferrals
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Adjusting for AccrualsAdjusting for Accruals ACCRUALS--actions that have been completed but for
which the cash has not changed hands (and the events are not yet recorded) ABC Company has a CD on which $500 of interest
had been earned during the year but not yet received (or recorded).
Interest receivable Interest revenue
500 500
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Adjusting for DeferralsAdjusting for Deferrals Deferrals--dollars have been exchanged and recorded
before the action is completed ABC Company paid $600 for rent on December 1.
The rent was for three months, beginning in December. When they paid it, ABC recorded it as Prepaid Rent. Now, on 12/31, one month’s worth of rent has been used.
* previously recorded
Prepaid Rent Rent Expense
600* 200 200
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The Goal of the Whole ProcessThe Goal of the Whole Process Financial Statements that reflect the financial
condition and transactions of the company Balance Sheet Income Statement Statement of Changes in Owners’ Equity Statement of Cash Flows
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Closing EntriesClosing Entries
All temporary accounts (income statement accounts and distributions) are closed at the end of the accounting period, after the statements are prepared.
Their balances are brought to ZERO, and the balancing entry is made to the retained earnings account.
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Closing EntriesClosing Entries Since revenue and expense accounts keep track of transactions for a period of time, we need them to be zero at the end of an accounting period.
To do this, we close them to retained earnings.
This effectively kicks them from the income statement to the balance sheet
Revenues & Expenses
IncomeStatement
BalanceSheet
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Journal Entries to Close Journal Entries to Close Revenue and Expense Accounts: Revenue and Expense Accounts: Closing EntriesClosing Entries
Revenue accounts have credit balances, so we must DEBIT them to close them (to get a zero balance)
What should we credit?
RETAINED EARNINGS
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Closing continued...Closing continued... To close expense accounts, we should
credit the expense account and debit the Retained Earnings account.
We are emptying the revenue and expense accounts…
All revenue and expense accounts will have a balance of ZERO after we close them.
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T-accountsT-accountsAn example of closingAn example of closing
Service Revenue
Salary Expense
Rent Expense
Retained Earnings
Bal.XXX
5000
1000
1500
5000
5000
1000
1000
1500
1500
Net Income
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Retained Earnings
Beginning balance
+ Net Income
Ending balance
The DISTRIBUTIONS (to owners) account is closed with a credit, since it has a debit balance, and a debit to RETAINED EARNINGS.
Distributions
$xxx $xxx
$xxx
One More Account to CloseOne More Account to Close
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Beginning balance
+ Net Income
Ending balance
- Distributions
Retained Earnings
A Final Look atA Final Look atRetained Earnings AccountRetained Earnings Account
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The Post-closing Trial Balance:The Post-closing Trial Balance:A trial balance written after closing the books is called a post-closing trial balance sheet.
ONLY the BALANCE SHEET ACCOUNTS -- the revenue and expense accounts have zero balances.
What accounts will be on this trial balance?