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Chapter2: Review of the Accounting Process

The Accounting Processing Cycle

Now that we've reviewed the basics of the double-entry system, let's look closer at the process used to identify, analyze, record, and summarize transactions and prepare financial statements. This section deals only with external transactions, those that involve an exchange transaction with another entity. Internal transactions are discussed in a later section.

   The 10 steps in the accounting processing cycle are listed in Graphic 2–3. Steps 1–4 take place during the accounting period while steps 5–8 occur at the end of the accounting period. Steps 9 and 10 are required only at the end of the year.

   We now discuss these steps in order.

   The first step in the process is to identify external transactions affecting the accounting equation. An accountant usually does not directly witness business transactions. A mechanism is needed to relay the essential information about each transaction to the accountant. Source documents relay essential information about each transaction to the accountant, e.g., sales invoices, bills from suppliers, cash register tapes. such as sales invoices, bills from suppliers, and cash register tapes serve this need.

 

STEP 1 Obtain information about transactions from source documents.

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GRAPHIC 2–3
The Accounting Processing Cycle

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   These source documents usually identify the date and nature of each transaction, the participating parties, and the monetary terms. For example, a sales invoice identifies the date of sale, the customer, the specific goods sold, the dollar amount of the sale, and the payment terms. With this information, the second step in the processing cycle, transaction analysis process of reviewing the source documents to determine the dual effect on the accounting equation and the specific elements involved., can be accomplished. Transaction analysis is the process of reviewing the source documents to determine the dual effect on the accounting equation and the specific elements involved.

 

STEP 2 Analyze the transaction.

   This process is summarized in Illustration 2–2 for the seven transactions described previously in Illustration 2–1. The item in each T-account is numbered to show the related transaction.

   The third step in the process is to record the transaction in a journal a chronological record of all economic events affecting financial position.. Journals provide a chronological record of all economic events affecting a firm. Each journal entry is expressed in terms of equal debits and credits to accounts affected by the transaction being recorded. Debits and credits represent increases or decreases to specific accounts, depending on the type of account, as explained earlier. For example, for credit sales, a debit to accounts receivable and a credit to sales revenue is recorded in a sales journal.

 

STEP 3 Record the transaction in a journal.

   A sales journal is an example of a special journal record of a repetitive type of transaction, e.g., a sales journal. used to record a repetitive type of transaction. Appendix 2C discusses the use of special journals in more depth. In this chapter and throughout the text, we use the general journal used to record any type of transaction. format to record all transactions.

   Any type of transaction can be recorded in a general journal. It has a place for the date of the transaction, a place for account titles, account numbers, and supporting explanations, as well as a place for debit entries, and a place for credit entries. A simplified journal entry is used throughout the text that lists the account titles to be debited and credited and the dollar amounts. A common convention is to list the debited accounts first, indent the credited accounts, and use the first of two columns for the debit amounts and the second column for the credit amounts. For example, the journal entry captures the effect of a transaction on fi nancial position in debit/credit form. for the bank loan in Illustration 2–1, which requires a debit to cash and a credit to note payable, is recorded as follows:

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To record the borrowing of cash and the signing of a note payable.

   Step 4 is to periodically transfer or post the debit and credit information from the journal to individual ledger accounts. Recall that a ledger is simply a collection of all of the company's various accounts. Each account provides a summary of the effects of all events and transactions on that individual account. This process is called posting transferring debits and credits recorded in individual journal entries to the specific accounts affected.. Posting involves transferring debits and credits recorded in individual journal entries to the specific accounts affected. As discussed earlier in the chapter, most accounting systems today are computerized, with the journal and ledger kept on disk. For these systems, the journal input information is automatically and instantly posted to the ledger accounts.

 

STEP 4 Post from the journal to the general ledger accounts.

p. 57

ILLUSTRATION 2–2
Transaction Analysis, the Accounting Equation, and Debits and Credits

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p. 58

   These first four steps in the processing cycle are illustrated using the external transactions in Illustration 2–3 which occurred during the month of July 2011, the first month of operations for Dress Right Clothing Corporation. The company operates a retail store that sells men's and women's clothing. Dress Right is organized as a corporation so owners' equity is classified by source as either paid-in capital or retained earnings.

ILLUSTRATION 2–3
External Transactions for July 2011

July

1

Two individuals each invested $30,000 in the corporation. Each investor was issued 3,000 shares of common stock.

 

1

Borrowed $40,000 from a local bank and signed two notes. The first note for $10,000 requires payment of principal and 10% interest in six months.The second note for $30,000 requires the payment of principal in two years.Interest at 10% is payable each year on July 1, 2012, and July 1, 2013.

 

1

Paid $24,000 in advance for one year’s rent on the store building.

 

1

Purchased furniture and fixtures from Acme Furniture for $12,000 cash.

 

3

Purchased $60,000 of clothing inventory on account from the Birdwell Wholesale Clothing Company.

 

6

Purchased $2,000 of supplies for cash.

 

4-31

During the month sold merchandise costing $20,000 for $35,000 cash.

 

9

Sold clothing on account to St. Jude’s School for Girls for $3,500. The clothing cost $2,000.

 

16

Subleased a portion of the building to a jewelry store. Received $1,000 in advance for the first two months’ rent beginning on July 16.

 

20

Paid Birdwell Wholesale Clothing $25,000 on account.

 

20

Paid salaries to employees for the first half of the month, $5,000.

 

25

Received $1,500 on account from St. Jude’s.

 

30

The corporation paid its shareholders a cash dividend of $1,000.

   The local bank requires that Dress Right furnish financial statements on a monthly basis. The transactions listed in the illustration are used to demonstrate the accounting processing cycle for the month of July 2011.

   For each transaction, a source document provides the necessary information to complete steps two and three in the processing cycle, transaction analysis and recording the appropriate journal entry. Each transaction listed in Illustration 2–3 is analyzed below, preceded by the necessary journal entry.

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To record the issuance of common stock.

   This first transaction is an investment by owners that increases an asset, cash, and also increases shareholders' equity. Increases in assets are recorded as debits and increases in shareholders' equity are recorded as credits. We use the paid-in capital account called common stock because stock was issued in exchange for cash paid in.2

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To record the borrowing of cash and the signing of notes payable.

   This transaction causes increases in both cash and the liability, notes payable. Increases in assets are debits and increases in liabilities are credits. The notes require payment of $40,000 in principal and $6,500 ([$10,000 × 10% × <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/6by12.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a> = $500] + [$30,000 × 10% × 2 years = $6,000]) in interest. However, at this point we are concerned only with the external transaction that occurs when the cash is borrowed and the notes are signed. Later we discuss how the interest is recorded.

p. 59

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To record the payment of one year’s rent in advance.

   This transaction increased an asset called prepaid rent, which is debited, and decreased the asset cash (a credit). Dress Right acquired the right to use the building for one full year. This is an asset because it represents a future benefit to the company. As we will see later, this asset expires over the one-year rental period.

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To record the purchase of furniture and fixtures.

   This transaction increases one asset, furniture and fixtures, and decreases another, cash.

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To record the purchase of merchandise inventory.

   This purchase of merchandise on account is recorded by a debit to inventory, an asset, and a credit to accounts payable, a liability. Increases in assets are debits, and increases in liabilities are credits.

   The Dress Right Clothing Company uses the perpetual inventory system to keep track of its merchandise inventory. This system requires that the cost of merchandise purchased be recorded in inventory, an asset account. When inventory is sold, the inventory account is decreased by the cost of the item sold. The alternative method, the periodic system, is briefly discussed on the next page, and Chapters 8 and 9 cover the topic of inventory in depth.

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To record the purchase of supplies.

   The acquisition of supplies is recorded as a debit to the asset account supplies (an increase) and a credit to the asset cash (a decrease). Supplies are recorded as an asset because they represent future benefits.

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To record the month’s cash sales and the cost of those sales.

   During the month of July, cash sales to customers totaled $35,000. The company's assets (cash) increase by this amount as does shareholders' equity. This increase in equity is recorded by a credit to the temporary account sales revenue.

   At the same time, an asset, inventory, decreases and retained earnings decreases. Recall that expenses are outflows or using up of assets from providing goods and services. Dress Right incurred an expense equal to the cost of the inventory sold. The temporary account cost of goods sold increases. However, this increase in an expense represents a decrease in shareholders' equity—retained earnings—and accordingly the account is debited. Both of these transactions are summary transactions. Each sale made during the month requires a separate and similar entry.

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To record a credit sale and the cost of that sale.

   This transaction is similar to the cash sale above. The only difference is that the asset acquired in exchange for merchandise is accounts receivable rather than cash.

ADDITIONAL CONSIDERATION

Periodic Inventory System

The principal alternative to the perpetual inventory system is the periodic system. This system requires that the cost of merchandise purchased be recorded in a temporary account called purchases. When inventory is sold, the inventory account is not decreased and cost of goods sold is not recorded. Cost of goods sold for a period is determined and the inventory account is adjusted only at the end of a reporting period.

   For example, the purchase of $60,000 of merchandise on account by Dress Right Clothing is recorded as follows:

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   No cost of goods sold entry is recorded when sales are made in the periodic system.

   At the end of July, the amount of ending inventory is determined (either by means of a physical count of goods on hand or by estimation) to be $38,000 and cost of goods sold for the month is determined as follows:

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   The following journal entry records cost of goods sold for the period and adjusts the inventory account to the actual amount on hand (in this case from zero to $38,000):

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   Inventory is discussed in depth in Chapters 8 and 9.

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To record the receipt of rent in advance.

   Cash increases by $1,000 so the cash account is debited. At this point, Dress Right does not recognize revenue even though cash has been received. Recall that the first criterion required for revenue recognition as stated in the realization principle is that the “earnings process is judged to be complete or virtually complete.” Dress Right does not earn the revenue until it has provided the jewelry store with the use of facilities; that is, the revenue is earned as the rental period expires. On receipt of the cash, a liability called unearned rent revenue increases and is credited. This liability represents Dress Right's obligation to provide the use of facilities to the jewelry store.

p. 61

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To record the payment of accounts payable.

   This transaction decreases both an asset (cash) and a liability (accounts payable). A debit decreases the liability and a credit decreases the asset.

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To record the payment of salaries for the first half of the month.

   Employees were paid for services rendered during the first half of the month. The cash expenditure did not create an asset since no future benefits result. Cash decreases and is credited; shareholders' equity decreases and is debited. The debit is recorded in the temporary account salaries expense.

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To record receipt of cash on account.

   This transaction is an exchange of one asset, accounts receivable, for another asset, cash.

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To record the payment of a cash dividend.

   The payment of a cash dividend is a distribution to owners that reduces both cash and retained earnings.

ADDITIONAL CONSIDERATION

An alternative method of recording a cash dividend is to debit a temporary account called dividends. In that case, the dividends account is later closed (transferred) to retained earnings along with the other temporary accounts at the end of the fiscal year. The journal entry to record the dividend using this approach is

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   We discuss and illustrate the closing process later in the chapter.


   Illustration 2–4 summarizes each of the transactions just discussed as they would appear in a general journal. In addition to the date, account titles, debit and credit columns, the journal also has a column titled Post Ref. (Posting Reference). This usually is a number assigned to the general ledger account that is being debited or credited. For purposes of this illustration, all asset accounts have been assigned numbers in the 100s, all liabilities are 200s, permanent shareholders' equity accounts are 300s, revenues are 400s, and expenses are 500s.

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ILLUSTRATION 2–4
The General Journal

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   The ledger accounts also contain a posting reference, usually the page number of the journal in which the journal entry was recorded. This allows for easy cross-referencing between the journal and the ledger. Page 1 is used for Illustration 2–4.

p. 63

   Step 4 in the processing cycle is to transfer (post) the debit/credit information from the journal to the general ledger accounts. Illustration 2–5 contains the ledger accounts (in T-account form) for Dress Right after all the general journal transactions have been posted. The reference GJ1 next to each of the posted amounts indicates that the source of the entry is page 1 of the general journal.

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ILLUSTRATION 2–5
General Ledger Accounts


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p. 64

   Before financial statements are prepared and before adjusting entries (internal transactions) are recorded at the end of an accounting period, an unadjusted trial balance a list of the general ledger accounts and their balances at a particular date. usually is prepared—step 5. A trial balance is simply a list of the general ledger accounts, listed in the order that they appear in the ledger, along with their balances at a particular date. Its purpose is to allow us to check for completeness and to prove that the sum of the accounts with debit balances equals the sum of the accounts with credit balances, that is, the accounting equation is in balance. The fact that the debits and credits are equal, though, does not necessarily ensure that the equal balances are correct. The trial balance could contain offsetting errors. As we will see later in the chapter, this trial balance also facilitates the preparation of adjusting entries.

   

STEP 5 Prepare an unadjusted trial balance.

   The unadjusted trial balance at July 31, 2011, for the Dress Right Clothing Corporation appears in Illustration 2–6. Notice that retained earnings has a debit balance of $1,000. This reflects the payment of the cash dividend to shareholders. The increases and decreases in retained earnings from revenue, expense, gain and loss transactions are recorded indirectly in temporary accounts. Before the start of the next year, these increases and decreases are transferred to the retained earnings account.

ILLUSTRATION 2–6
Unadjusted Trial Balance

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At any time, the total of all debit balances should equal the total of all credit balances.

CONCEPT REVIEW EXERCISE

The Wyndham Wholesale Company began operations on August 1, 2011. The following transactions occur during the month of August.

   

JOURNAL ENTRIES FOR EXTERNAL TRANSACTIONS

a.

 

Owners invest $50,000 cash in the corporation in exchange for 5,000 shares of common stock.

b.

 

Equipment is purchased for $20,000 cash.

c.

 

On the first day of August, $6,000 rent on a building is paid for the months of August and September.

d.

 

Merchandise inventory costing $38,000 is purchased on account. The company uses the perpetual inventory system.

e.

 

$30,000 is borrowed from a local bank, and a note payable is signed.

f.

 

Credit sales for the month are $40,000. The cost of merchandise sold is $22,000.

g.

 

$15,000 is collected on account from customers.

h.

 

$20,000 is paid on account to suppliers of merchandise.

i.

 

Salaries of $7,000 are paid to employees for August.

p. 65

j.

 

A bill for $2,000 is received from the local utility company for the month of August.

k.

 

$20,000 cash is loaned to another company, evidenced by a note receivable.

l.

 

The corporation pays its shareholders a cash dividend of $1,000.


Required:

1.

 

Prepare a journal entry for each transaction.

2.

 

Prepare an unadjusted trial balance as of August 31, 2011.


SOLUTION

1.

 

Prepare a journal entry for each transaction.


a.

 

The issuance of common stock for cash increases both cash and shareholders' equity (common stock).

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b.

 

The purchase of equipment increases equipment and decreases cash.

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c.

 

The payment of rent in advance increases prepaid rent and decreases cash.

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d.

 

The purchase of merchandise on account increases both inventory and accounts payable.

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e.

 

Borrowing cash and signing a note increases both cash and note payable.

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f.

 

The sale of merchandise on account increases both accounts receivable and sales revenue. Also, cost of goods sold increases and inventory decreases.

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g.

 

The collection of cash on account increases cash and decreases accounts receivable.

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h.

 

The payment of suppliers on account decreases both accounts payable and cash.

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p. 66

i.

 

The payment of salaries for the period increases salaries expense (decreases retained earnings) and decreases cash.

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j.

 

The receipt of a bill for services rendered increases both an expense (utilities expense) and accounts payable. The expense decreases retained earnings.

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k.

 

The lending of cash to another entity and the signing of a note increases note receivable and decreases cash.

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l.

 

Cash dividends paid to shareholders reduce both retained earnings and cash.

Retained earnings3 .........................................................................................
1,000
Cash ........................
1,000

2.

 

Prepare an unadjusted trial balance as of August 3l, 2011.

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2The different types of stock are discussed in Chapter 18.

3An alternative is to debit a temporary account—dividends—that is closed to retained earnings at the end of the fiscal year along with the other temporary accounts.

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