CHAPTER 2

THE ACCOUNTING CYCLE: DURING THE PERIOD

PART A
MEASURING BUSINESS ACTIVITIES

ACCOUNTING CYCLE

(MUST IDENTIFY AND ANALYZE TRANSACTIONS FIRST)

EFFECT OF TRANSACTIONS ON THE (BASIC/EXPANDED) ACCOUNTING EQUATION

The ACCOUNTING EQUATION is illustrated as follows:

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends

SEVERAL/VARIOUS ILLUSTRATIONS OF TRANSACTIONS

1. Issue (Sell) Common Stock For Cash

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends

2. Borrow Cash From Bank

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends

3. Purchase Computers For Cash

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends

4. Paid Insurance In Advance

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends
5. Purchase Supplies On Account

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
(A/P) Revenue – Expenses = Net Income (Loss)/-Dividends

6. Provide Services For Cash

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends

(REVENUE RECOGNITION PRINCIPLE)

7. Provide Services On Account

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
(A/R) Revenue – Expenses = Net Income (Loss)/-Dividends

(REVENUE RECOGNITION PRINCIPLE)

8. Receive Cash (Payment) In Advance For Services To Be Provided

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends
(DEFERRED REVENUE (UNEARNED REVENUE))

9. Paid Rent For The Current Month

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends

10. Paid Cash Dividends

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends

(COMPOUND TRANSACTIONS (INVOLVE MORE THAN TWO (2) ITEMS))

REVENUE RECOGNITION PRINCIPLE (ACCRUAL BASIS OF

ACCOUNTING)
(Revenue is RECOGNIZED at the time when Goods And Services are provided)
(See Transactions (6) and (7) above (but not for Transaction (8))
PART B
DEBITS AND CREDITS

An ACCOUNT is a record or device used to record increases and decreases in a single

item. (This is where Accounting transactions are recorded). The GENERAL LEDGER
is where all ACCOUNTS of a company are maintained. The CHART OF ACCOUNTS
is a listing of ACCOUNTS and Account Numbers in the GENERAL LEDGER.

The order for the listing of ACCOUNTS in the GENERAL LEDGER) and the
CHART OF ACCOUNTS is as follows:

 Assets
 Liabilities
 Owner's Equity (Stockholders' Equity/Dividends)
 Revenues
 Expenses

The ACCOUNTS are usually numbered as follow:

 Assets (100's)
 Liabilities (200's)
 Owner's Equity (300's) (Stockholders' Equity/Dividends)
 Revenues (400's)
 Expenses (500's)

EFFECT ON ACCOUNT BALANCES IN THE BASIC ACCOUNTING EQUATION

A teaching tool that is often used in discussing and describing ACCOUNTS is a

“T ACCOUNT”. A T ACCOUNT is simply an illustration of a T with two

(2) sides to it (see Page 67 in the book). The left side of an ACCOUNT (T
ACCOUNT) is known as the DEBIT SIDE where DEBITS to an ACCOUNT are
made. (Making an entry on the left side of an ACCOUNT (T ACCOUNT) is
called "DEBITING"). The right side of an ACCOUNT (T ACCOUNT) is known
as the CREDIT SIDE where CREDITS to an ACCOUNT are made. (Making an
entry on the right side of an ACCOUNT (T ACCOUNT) is called
"CREDITING"). The difference between the total of the amounts recorded on
the left side of an ACCOUNT (T ACCOUNT) (ie. total DEBITS) and the
amounts recorded on the right side of an ACCOUNT (T ACCOUNT) (ie. total
CREDITS) is known as the BALANCE of the ACCOUNT. If the total amounts
recorded on the left side (DEBIT SIDE (ie. DEBITS)) of an ACCOUNT (T
ACCOUNT) are more than the total amounts recorded on the right side (CREDIT
SIDE (ie. CREDITS)) of an ACCOUNT (T ACCOUNT), the ACCOUNT is said
to have a DEBIT BALANCE. If the total amounts recorded on the right side
(CREDIT SIDE (ie. CREDITS)) of an ACCOUNT (T ACCOUNT) are more than
the total amounts recorded on the left side (DEBIT SIDE (ie. DEBITS)) of an
ACCOUNT (T ACCOUNT), the ACCOUNT is said to have a CREDIT
BALANCE.

The effect of DEBITS and CREDITS made to an ACCOUNT depends on the type
of ACCOUNT that is being DEBITED or CREDITED. ASSETS are increased
(ie. made larger) with DEBITS and are decreased (ie. made smaller) with
CREDITS. ASSETS have a NORMAL DEBIT BALANCE (See below for
explanation of NORMAL BALANCE). LIABILITIES are increased (ie. made
larger) with CREDITS and are decreased (ie. made smaller) with DEBITS.
LIABILITIES have a NORMAL CREDIT BALANCE. (See below for
explanation of NORMAL BALANCE). OWNER'S EQUITY
(STOCKHOLDERS' EQUITY) is increased (ie. made larger) with CREDITS and
is decreased (ie. made smaller) with DEBITS. OWNER'S EQUITY
(STOCKHOLDERS' EQUITY) has a NORMAL CREDIT BALANCE. (See
below for explanation of NORMAL BALANCE). REVENUES are increased (ie.
made larger) with CREDITS and are decreased (ie. made smaller) with DEBITS.
REVENUES have a NORMAL CREDIT BALANCE. (See below for
explanation of NORMAL BALANCE). EXPENSES are increased (ie. made
larger) with DEBITS and are decreased (ie. made smaller) with CREDITS.
EXPENSES have a NORMAL DEBIT BALANCE. (See below for explanation
of NORMAL BALANCE). DIVIDENDS are increased (ie. made larger) with
DEBITS and are decreased (ie. made smaller) with CREDITS. DIVIDENDS
have a NORMAL DEBIT BALANCE. (See below for explanation of
NORMAL BALANCE). (Notice that ASSETS, EXPENSES and DIVIDENDS
are affected the same way with DEBITS and CREDITS and LIABILITIES,
OWNER'S EQUITY (STOCKHOLDERS' EQUITY) and REVENUES are
affected the same way with DEBITS and CREDITS). (See the following
illustrations of T ACCOUNTS)
The ACCOUNTING EQUATION is illustrated as follows:

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY (OWNER'S EQUITY)

(1) Common Stock (2) Retained Earnings
Revenue – Expenses = Net Income (Loss)/-Dividends

ASSETS

DEBIT CREDIT
SIDE SIDE

+ -

NORMAL
BALANCE

LIABILITIES

DEBIT CREDIT
SIDE SIDE

- +

NORMAL
BALANCE

(STOCKHOLDERS')
OWNER'S EQUITY

DEBIT CREDIT
SIDE SIDE

- +

NORMAL
BALANCE

EFFECT ON ACCOUNT BALANCES IN THE EXPANDED ACCOUNTING EQUATION

 COMMON STOCK

DEBIT CREDIT
SIDE SIDE

- +

NORMAL
BALANCE

RETAINED EARNINGS

DEBIT CREDIT
SIDE SIDE

- +

NORMAL
BALANCE

REVENUES

DEBIT CREDIT
SIDE SIDE

- +

NORMAL
BALANCE

EXPENSES

DEBIT CREDIT
SIDE SIDE

+ _

NORMAL
BALANCE
DIVIDENDS
 DEBIT CREDIT
SIDE SIDE

+ _

NORMAL
BALANCE

(APPLY ALL TEN (10) TRANSACTIONS ABOVE THROUGH DEBITS AND CREDITS)

The total DEBITS made for each Accounting transaction must equal the total CREDITS
made for that Accounting transaction. This is known as DOUBLE-
ENTRYACCOUNTING System. The DOUBLE-ENTRY ACCOUNTING System
enables for the ACCOUNTING EQUATION (ie. ASSETS = LIABILITIES +
STOCKHOLDERS' EQUITY (OWNER'S EQUITY) to be maintained. Thus, the
total DEBITS for each Accounting transaction must equal the total CREDITS for that
Accounting transaction.

The "NORMAL BALANCE" of an ACCOUNT is the BALANCE that an ACCOUNT is

usually expected to have. (It is possible for an ACCOUNT to have a BALANCE
opposite its NORMAL BALANCE but is usually not likely). The NORMAL BALANCE
of an ACCOUNT is always the side of the ACCOUNT that is increased. Thus, the
NORMAL BALANCE of ACCOUNTS is summarized as follow:

 Assets (Debit Balance)

 Liabilities (Credit Balance)
 Owner's (Stockholders') Equity (Credit Balance)
 Revenues (Credit Balance)
 Expenses (Debit Balance)
 Dividends (Debit Balance)

RECORDING TRANSACTIONS IN A JOURNAL

The Recording Process of recording Accounting transactions includes making an entry

("JOURNAL ENTRY") in a JOURNAL. The GENERAL JOURNAL (the book uses
the term "Journal" only) is a book of original entry (ie. Where Accounting transactions
are initially recorded). The GENERAL JOURNAL is usually in columnar format with a
column for "Date", "Description (And Explanation)" (or "Account Item And
Explanation"), "Post. Ref." (abbreviation for Posting Reference), "Debits" (often
abbreviated "Dr.") and "Credits" (often abbreviated "Cr."). (In addition, the GENERAL
JOURNAL (JOURNAL) page number also appears at the top of each page of the
GENERAL JOURNAL (JOURNAL). (See page 70 in the book for an illustration of the
GENERAL JOURNAL format)). ACCOUNTS that are DEBITED in a JOURNAL
ENTRY are always listed first and ACCOUNTS that are CREDITED in a JOURNAL
ENTRY are always listed second (ie. after the ACCOUNTS that are DEBITED) and are
usually slightly indented in the GENERAL JOURNAL (JOURNAL). The advantages
and benefits of initially recording an Accounting transaction in a GENERAL JOURNAL
(JOURNAL) is (1) a complete transaction is recorded in one place, (2) a chronological
record of all Accounting transactions is maintained and (3) helps to prevent or locate
errors. The process of recording Accounting transactions in the GENERAL JOURNAL
(JOURNAL) is known as JOURNALIZING. A JOURNAL ENTRY that involves more
than two (2) ACCOUNTS is known as a COMPOUND ENTRY. A JOURNAL
ENTRY may involve an unlimited number of ACCOUNTS as long as the total DEBITS
of the JOURNAL ENTRY equal the total CREDITS of the JOURNAL ENTRY (ie.
DOUBLE ENTRY ACCOUNTING System). An example of a COMPOUND ENTRY is
as follows:
Debit Credit
Equipment $30,000 $
Cash 10,000
Accounts Payable 20,000

(APPLY A COUPLE OF THE TEN (10) TRANSACTIONS ABOVE THROUGH

THE GENERAL JOURNAL)

EXERCISES 2-8, 2-11 AND 2-12

POSTING TO THE GENERAL LEDGER

The process of transferring (the DEBITS and CREDITS of) JOURNAL ENTRIES from
the GENERAL JOURNAL (JOURNAL) to the specific ACCOUNTS in the GENERAL
LEDGER is known as POSTING. The ACCOUNTS in the GENERAL LEDGER are
usually in columnar format with a column for "Date", "Item", "Post. Ref." (abbreviation
for Posting Reference), "Debit", “Credits" and "Balance". (In addition, the Account
Name and Account Number also appear at the top of the ACCOUNT). The GENERAL
JOURNAL (JOURNAL) page where the Accounting transaction was initially recorded is
inserted in the "Post. Ref." Column of the ACCOUNT and the Account Number of the
specific ACCOUNT the Accounting transaction is being posted to is inserted in the "Post.
Ref." column of the GENERAL JOURNAL (JOURNAL). (This is a way of connecting
the specific ACCOUNT in the GENERAL LEDGER with where the Accounting
transaction was initially recorded in the GENERAL JOURNAL (JOURNAL) in case
there is a need to later trace the Accounting transaction back to its origination). (See
page 72 of the book for an illustration of a Standard Form of General Ledger ACCOUNT
format. Note that instead of the two (2) columns shown for the "Balance" (ie. "Debit"
and "Credit") of the ACCOUNT, an ACCOUNT may be illustrated with one (1) single
column for the "Balance" of the ACCOUNT with a Credit Balance (or opposite Normal
Balance) shown in brackets or in parenthesis).

EXERCISE 2-15
TRIAL BALANCE
(INTERNAL PURPOSES ONLY)
A TRIAL BALANCE is a two (2) column schedule listing all ACCOUNTS in the
GENERAL LEDGER that have BALANCES as of a specific date. The purpose of the
TRIAL BALANCE is to prove the mathematical accuracy of the DEBITS and
CREDITS of the ACCOUNTS in the GENERAL LEDGER. The order of the
ACCOUNTS listed in the TRIAL BALANCE is the same as the order of the
ACCOUNTS listed in the GENERAL LEDGER (and the CHART OF ACCOUNTS) as
described above and presented again as follows:

 Assets
 Liabilities
 Owner's Equity (Stockholders' Equity/Dividends)
 Revenues
 Expenses

If the total DEBITS and total CREDITS of the ACCOUNTS in the GENERAL LEDGER
equal, this is not absolute proof that there are no errors in the Accounting records (ie.
does not prove that all Accounting transactions have been recorded or that the
GENERAL LEDGER is correct) but this does provide some comfort. (For example, (1)
transaction not recorded, (2) correct JOURNAL ENTRY not posted, (3) JOURNAL
ENTRY posted twice, (4) incorrect amount used in JOURNALIZING or POSTING and
(5) offsetting error made in recording amount of a transaction. If any of these errors
occurred during the Recording Process, the total DEBITS of the ACCOUNTS in the
GENERAL LEDGER will still equal the total CREDITS of the ACCOUNTS in the
GENERAL LEDGER but errors were still made during the Recording Process). If the
total DEBITS and total CREDITS of the ACCOUNTS in the GENERAL LEDGER do
not equal, this is absolute certainty that an error has occurred in the Recording Process.
The TRIAL BALANCE is very useful in preparing FINANCIAL STATEMENTS.

EXERCISE 2-17

The steps of the ACCOUNTING CYCLE (slightly modified from as described in the
textbook) are as follows:

(1) Journalize the transactions (JOURNALIZING)

(2) Post the entries to the specific accounts in the GENERAL LEDGER (POSTING)
(3) Prepare the (UNADJUSTED) TRIAL BALANCE

(More to come in Chapter 3)