Chapter 4

Accounting
Records and
Systems

McGraw-Hill/Irwin

Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.

Chapter Overview
No new concepts introduced.
Recordkeeping fundamentals.
Focus on manual system because easier to
visualize.

Why? Accounting is best learned by

doing.
Debit-credit mechanism provides an
analytical framework.
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The Account
Device used for calculating net change in
an item (e.g., cash, inventory, wage
expense).
Simplest form is T-account.
Increases listed on one side; decreases
listed on other side (Note: Which side
depends on type of account).
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Permanent Accounts
Also called real accounts or balance
sheet accounts.
Reported on balance sheet.
Carried forward into next period:
In this sense, they are permanent.

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Temporary Accounts
Revenue and expense accounts.
Helps summarize operating activity.
Avoids cluttering retained earnings
account.
Why temporary?
At end of accounting period, balances are
transferred to retained earnings.
Therefore, balances at beginning are zero.
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General Ledger
General ledger contains all accounts.
Some accounts may be in summary form.
E.g., accounts receivable, inventory, fixed
assets.
Detail or subsidiary ledgers kept for above.

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Chart of Accounts
List of all accounts.
Numbers assigned to accounts to make
summaries for Balance Sheet and Income
Statement easier.
Management determines number of
accounts based on information needs.
May be several levels of detail.
Can view as building blocks summarized
in various ways.
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Debit and Credit

Left hand side of an account
arbitrarily called debit side.
Right hand side is credit side.

Account Name
Debit Credit

To debit is to record on
left hand side.
To credit is to record on
right hand side.
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Fundamental Accounting
Equation
Assets
Debit Credit

Liabilities
Debit Credit

Owners Equity
Debit Credit

For each transaction:

dr. (debit) = cr. (credit).
Assets = Liabilities + Owners Equity.
Thus, double-entry bookkeeping.
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Fundamental Accounting
Equation
Assets
Debit Credit

Liabilities
Debit Credit

Owners Equity
Debit Credit

Increase (decrease) assets with debit (credit).

Increase (decrease) liabilities and owners
equity with credit (debit).
Why opposite? Maintain equality of
accounting equation.
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Revenues and Expenses

Revenues

Expenses

Debit Credit

Debit Credit

Revenues and expenses can be viewed as extension

of retained earnings (owners equity).
Increase (decrease) revenues with credit (debit).
Increase (decrease) expenses with debit (credit).
Why?
Revenues increase retained earnings.
Expenses decrease retained earnings.

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Summary of
Accounting Process (Cycle)
1.
2.

Analyze transactions.
Journalize original entries.
Record chronologically in journal.

3.

Post journal entries to ledger.

Organize by account.

4.

Identify, journalize, and post adjusting entries.

Per matching concept.

5.

Journalize and post closing entries.

Close out temporary accounts.

6.

Prepare financial statements.

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Transaction Analysis
Determine dual effect on accounts.
Assets = Liabilities + Owners Equity.
dr. (debit) = cr. (credit).

Advice: Record half of entry that is more

obvious.

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Examples
Owner invests $5,000 in business.
Cash
Paid-In Capital
Debit Credit

$5,000

Debit Credit

$5,000

Business pays $750 for rent.

Cash
Prepaid Expenses
Debit Credit

$5,000 $750

Debit Credit

$750

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Trial Balance
Prepare after original entries are journalized
and then posted to ledger.
List of all accounts and their ending balance.

Assets (debit balance).

Liabilities (credit balance).
Owners equity (credit balance).
Revenues (credit balance).
Expenses (debit balance).
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Trial Balance
Why prepare?
Shows equality of debits and credits (i.e.,
maintained integrity of accounting
equation).
But still could be errors.

Convenient summary for making

adjusting entries and preparing financial
statements.
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Adjusting Entries
Modifies account balances at end of period
to fairly reflect financial situation.
Types:
Recorded costs related to two or more periods
(e.g., insurance, depreciation).
Unrecorded expenses (e.g., employee wages,
bad debts).
Recorded revenues related to two or more
periods (e.g., rent revenue).
Unrecorded revenues (e.g., interest earned).
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Adjusting Entry for Insurance

Business purchases two year insurance policy on
Jan 1 for $1,600.

Original
Entry

Adjusting
Entry

Prepaid Insurance
Debit Credit

$1,600

Insurance Expense
Debit Credit

$800

Cash
Debit Credit

$1,600

Prepaid Insurance
Debit Credit

$1,600

$800
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Adjusting Entry for Depreciation

Business purchases $10,000 of equipment on Jan 1.
Has useful life of 5 years, $0 salvage value.

Original
Entry

Equipment
Debit Credit

$10,000

Cash
Debit Credit

$10,000

Depreciation Expense Accumulated Depreciation

Adjusting
Entry

Debit Credit

$2,000

Debit Credit

$2,000
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Adjusting Entry for Bad Debts

Business makes $10,000 of sales on credit.
Estimates $300 will be uncollectible.

Original
Entries

Adjusting
Entry

Accounts Receivable
Debit Credit

$10,000

Sales Revenues
Debit Credit

$10,000

Bad Debt Expense

Allowance for
Doubtful Accounts

Debit Credit

Debit Credit

$300

$300
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Closing Entries
Temporary (i.e., income statement) accounts
are closed out to the Income Summary.
Clearing account.
Also called Profit & Loss, Expense and Revenue
Summary.
Result is zero balance in temporary accounts.

Income summary account is then closed out

to Retained Earnings.
Only permanent accounts will then have balances.
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Financial Statement
Preparation
Income Statement.
Balances in temporary accounts prior to
closing, or
Debits and credits to Income Summary
accounts.

Balance Sheet.
Balances in permanent accounts.
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Objectives of Accounting
System
Process information efficiently (i.e., low
cost).
Obtain reports quickly.
Ensure a high degree of accuracy.
Minimize possibility of theft or fraud.

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Internal Accounting Controls

Basic principle: Make it difficult (as is
practical) for people to be dishonest or
careless.
Activities that reduce possibility of theft, or
intentional or unintentional mistakes.
Accuracy checks (e.g., trial balance, bank
reconciliation).
Segregation of duties (i.e., record keeping,
custody of assets, authorization of
transactions).
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Computer-Based Accounting
Systems
Performs some or all bookkeeping
(mechanical) steps:

Records and stores data.

Performs arithmetic operations on data.
Sorts and summarizes data.
Prepares reports.

More efficient than manual systems.

Off-the-shelf systems available for small
companies.
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Computer-Based Accounting
Systems
Inputs.
Manually entered or scanned in.

Processing.
Chance for errors reduced (e.g., only
accept entries if debits equal credits).

Outputs.
Tables, graphs, etc.
Routine or customized.
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Computer-Based Accounting
Systems
Modules.
Interconnected software programs.
Examples:
Order entry module (i.e., processes sales
orders, records shipments, records accounts
receivable).
Purchasing module (i.e., issues purchase
orders, tracks inventory, records accounts
payable).
Payroll and personnel records.
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Computer-Based Accounting
Systems
Potential problems.
Modifying to unique complexities of a
company may be costly.
Paper trail replaced by electronic
records.
Technological advances can make
systems obsolete.
Challenge of educating users.
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