The Accounting Process

LECTURE 2

Accounting Equation
ASSETS = LIABILITIES + OWNERS EQUITY
Accounting Equation provides the underlying framework for
recording and summarizing economic events.
Assets are claimed by either creditors or owners (Residual Claim)
Claims of creditors must be paid before ownership claims.
Assets:

Resources a business own

Provide future benefits and/or services

Example, Cash, Supplies, Inventory, Receivables (Short-term or Current Assets),

Property, Plant & Equipment (Long-term or Fixed or Non Current Assets)

Accounting Equation
Liabilities:
Claims against assets (Debts and Future/Current Obligations)
Creditors Party (Suppliers) to whom money is owed
Example, Accounts payable, Wages Payable, (Short-term/Current
Liabilities) Notes payable, Bonds Payables, Lease Obligations
(Long-term/Non Current Liabilities)

Owners Equity:
Ownership claim on total assets
Referred to as residual equity
Owners Equity = Investment by owners + Profits
Drawings/Dividends

Profit = Revenues Expenses

Accounting Equation
Expanded Accounting Equation:
Assets = Liabilities + Owners Capital + Revenues
Expenses Owners Drawings (for Sole
proprietorship)

Assets = Liabilities + Common Stock+ Revenues

Expenses Dividend (for Corporations)

Accounting Equation
Revenues: result from business activities entered into for the purpose of
earning income, Revenue is recognized when the goods or services are
provided, whether realized or realizable
(Revenue Recognition Principle)

Common sources of revenues: sales (for merchandising or manufacturing organizations) fees,

services, commissions, royalties (for service organizations) interest, dividends, and rent

Expenses: are the cost of assets consumed or services used in the process of
earning revenue. Expenses are recognized when the related revenues are
recognized, whether paid or not
(Matching Principle)

Common expenses are: Cost of Goods Sold (for merchandising or manufacturing

organizations), Salaries expense, Rent expense, Utilities expense, Tax expense (Common
to all forms of organizations)

Transactions
Transactions (business transactions): are a businesss economic events recorded
by accountants
Transactions may be external or internal.
External transactions: involve economic events between the company and

some outside enterprise. For example, purchase of equipment from a supplier,

payment rent, and sale of goods or services to customers is external transactions.

Internal transactions: are economic events that occur entirely within one

company. The uses of equipment to produce goods or services are internal

transactions
All events are not transactions. If an event fulfills the following features it

will be recognized as a transaction

It can be measured in monetary terms
It will change the financial position of the business
Each Transaction must have a dual effect on the accounting equation

Transaction Identification Process

Transaction Analysis (Service

Organization)
Ray Neal decides to open
a computer programming service which he

names Softbyte. On September 1, 2012, Ray Neal invests $15,000 cash

in the business
[Cash (asset) increased by $15,000; and Ray Neals Capital (owners
equity) increased by $15,000]
Sep. 2 Softbyte purchases computer equipment for $7,000 cash
[Equipment (assets) increased by $7,000; and Cash (asset) decreased
by $7,000]
Sep. 3 Softbyte purchases for $1,600 from Acme Supply Company
computer paper and other supplies expected to last several months.
The purchase is made on account
[Supplies (assets) increased by $1,600; and Accounts Payable
(Liability) increased by $1,600]
Sep. 10 Softbyte receives $1,200 cash from customers for programming
services it has provided
[Cash (assets) increased by $1,200; and Service Revenue (revenue)

Transaction Analysis
Sep. 15 Softbyte receives a bill for $250 from the Daily News for
advertising but postpones payment until a later date
[Accounts Payable (liability) increased by $250; and Advertising
Expense (expense) increased by $250]
Sep. 20 Softbyte provides $3,500 of programming services for
customers. The company receives cash of $1,500 from customers,
and it bills the balance of $2,000 on account
[Cash (assets) increased by $1,500; Accounts Receivable (asset)
increased by $2,000; and Service Revenue (revenue) increased by
$3,500]
Sep. 25 Softbyte pays the following expenses in cash for September:
store rent $600, salaries of employees $900 and utilities $200
[Rent Expense, Salaries Expense, Utility Expense (expenses)
increased by $600, $900, and $200 respectively; and Cash (asset)
decreased by $1,700]

Transaction Analysis
Sep. 27 Softbyte pays its $250 Daily News bill in cash
[Accounts Payable (liability) decreased by $250; and
Cash (asset) decreased by $250
Sep. 28 Softbyte receives $600 in cash from customers
who had been billed for services [in Transaction Sep.
20]
[Cash (asset) increased by $600; and Accounts
Receivables (asset) decreased by $600]
Sep. 30 Ray Neal withdraws $1,300 in cash from the
business for his personal use
[Cash (asset) decreased by $1,300; and Ray Neals
Drawings (owners equity) decreased by $1,300]

Transaction Analysis (Merchandising Organization)

Halogen Clothing Company began business on July 1, 2013. During July,

2013 the following transactions occurred:

July 1: Issued common stock in exchange of cash to twenty individuals each
invested $10,000 in the corporation. Each investor was issued 1,000 shares of
common stock
[Cash (asset) increased by $200,000; and Common Stock (owners equity)
increased by $200,000]
July 1: Borrowed $50,000 from a local bank and signed two notes. The first
note for $20,000 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, 2014, and July 1,
2015.
[Cash (asset) increased by $50,000; and Notes Payable (liability) increased by
$50,000]
July 1: Paid $24,000 in advance for one years rent on the store building.
[Prepaid Rent (asset) increased by $24,000; and Cash (asset) decreased by
$24,000]

Transaction Analysis
July 1: Purchased furniture and fixtures from Acme
Furniture for $40,000 cash.
[Furniture & Fixtures (asset) increased by $40,000;
and Cash (asset) decreased by $40,000]
July 3: Purchased $160,000 of merchandise inventory
on account from the Birdwell Wholesale Clothing
Company
[Merchandise Inventory (asset) increased by $160,000;
Accounts Payable (liability) increased by $160,000]
July 6: Purchased $2,000 of supplies for cash
[Office Supplies (asset) increased by $2,000; and Cash
(asset) decreased by $2,000]

Transaction Analysis
July 10: Sold merchandise inventory costing $100,000 for $135,000
cash
[Cash (asset) increased by $135,000; and Sales (revenue) increased
by $135,000]
[Cost of Goods Sold (expense) increased by $100,000; and
Merchandise Inventory (asset) decreased by $100,000]
July 15: Sold merchandise inventory on account to St. Judes School
for Girls for $35,500. The merchandise inventory costs $20,000
[Accounts Receivable (asset) increased by $35,500; and Sales
(revenue) increased by $35,500]
[Cost of Goods Sold (expense) increased by $20,000; and
Merchandise Inventory (asset) decreased by $20,000]

Transaction Analysis
July 16: Subleased a portion of the building to a jewelry store. Received
$4,000 in advance for the first two months rent beginning on July 16
[Cash (asset) increased by $4,000; Unearned Rent (unearned revenue- a
liability) increased by $4,000]
July 20: Paid Birdwell Wholesale Clothing $100,000 on account
[Accounts Payable (liability) decreased by $100,000; and Cash (asset)
decreased by $100,000]
July 20: Received $25,500 on account from St. Judes School
[Cash (asset) increased by $25,500; and Accounts Receivable (asset)
decreased by $25,500]
July 31: Paid salaries to employees for the first month, $15,000
[Salaries Expense (expense) increased by $15,000; and Cash (asset)
decreased by $15,000]
July 30: The Corporation paid its shareholders a cash dividend of $5,000
[Dividend (owners equity) decreased by $5,000; and Cash (asset)
decreased by $5,000]

Recording Process

Account
An account is an individual accounting record of increases

and decreases in a specific Asset, Liability, Owners Equity,

Revenue and Expense item

For example, Softbyte would have separate accounts for

Cash, Accounts Receivable, Accounts Payable, Service

Revenue, Salaries and Wages Expense, and so on
(Note that whenever we are referring to a specific account,
we capitalize the name)

The Account

An Account can be
illustrated in a TAccount form.

Debit Credit Procedure

Double-entry system

Each transaction must affect two or more accounts (Dual Effect)

to keep the basic accounting equation in balance
Each Debit must have a corresponding Credit with Similar Amount

Recording done by debiting at least one account and crediting

another
DEBITS must equal CREDITS

If sum of the Debits are greater than the sum of the Credits, the
account will have a Debit Balance
If sum of the Credits are greater than the sum of the Debits, the
account will have a Credit Balance

Debit Credit Rule

If Asset Increases
Specific Asset Account is to be Debited
If Asset Decreases
Specific Asset Account is to be Credited
If Liability Increases
Specific Liability Account is to be Credited
If Liability Decreases
Specific Liability Account is to be Debited
If Owners Equity Increases
Specific Equity Account is to be Credited
If Owners Equity Decreases
Specific Equity Account is to be Debited

Debit Credit Rule

If Revenue Increases
Specific Revenue Account is to be Credited
If Revenue Decreases
Specific Revenue Account is to be Debited
If Expenses Increases
Specific Expense Account is to be Debited
If Expenses Decreases
Specific Expense Account is to be Credited

Steps in Recording Process - Journal

The Journal:

Book of original entry.

Transactions recorded in chronological order.

Contributions to the recording process:

Discloses the complete effects of a transaction

Provides a chronological record of transactions

Helps to prevent or locate errors because the

debit and credit amounts can be easily compared

Journalizing
Entering transaction data in the journal
General Journal
Date
Sep. 1

Account Title

Cash
Ray Neals Capital

Reference

Debit

Credit

$15000
$15000

To record capital invested by

Ray Neal (Owner) in the
business
Sep. 2

Equipment
Cash

7000
7000

To record Equipment purchased

for Cash
Sep. 3

Supplies
Accounts Payable
To record Supplies purchased on
credit

1600
1600

Journalizing
General Journal
Date
Sep. 10

Account Title

Cash
Service Revenue

Reference

Debit

Credit

$1200
$1200

To record service revenue

provided for cash
Sep. 15

Advertising Expense
Accounts Payable

250
250

To record advertisement
expense on credit
Sep. 20

Cash
Accounts Receivable
Service Revenue
To record service revenue
provided for cash and credit

1500
2000
3500

Journalizing
General Journal
Date
Sep. 25

Account Title

Rent Expenses

Reference

Debit

Credit

$600

Salaries Expenses

900

Utilities Expenses

200

Cash

$1700

To record various expenses

paid in cash
Sep. 27

Accounts Payable
Cash
To record liabilities paid in
cash

250
250

Journalizing
General Journal
Date
Sep. 28

Account Title

Cash

Reference

Debit

Credit

$600

Accounts Receivables

$600

To record cash collected from

customers
Sep. 30

Ray Neals Drawings

Cash
To record cash withdrawal by
Ray Neal (Owner)

1300
1300

Posting of transaction General Ledger

General Ledger contains the entire group of accounts maintained by a
company

Standard Form of Ledger Account

Perpetual Balancing
Date

Explanation

Ref. Debit

Credit Balance

Traditional form of Ledger Account

T Account (Periodical Balancing)
Date Explanation

Ref. Debit

Date Explanation

Ref.

Credit

Recoding Process General Ledger

Posting process of transferring amounts from the journal to
the ledger accounts
Accounts and account numbers arranged in sequence in
which they are presented in the financial statements
Follow these steps:
1.

Determine what type of account is involved.

2.

Determine what items increased or decreased and by

how much.

3.

Translate the increases and decreases into debits and

credits

General Ledger
Cash Account
Date

Explanation

Ref. Debit

Credit

Sep. 1

Ray Neals Capital

Sep. 2

Equipment

Sep. 10

Service Revenue

1200

9200

Sep. 20

Service Revenue

1500

10700

Sep. 25

Rent Expenses

600

10100

Sep. 25

Salaries Expense

900

9200

Sep. 25

Utilities Expenses

200

9000

Sep. 27

Accounts Payable

250

8750

Sep. 28

Accounts Receivable

Sep. 30

Ray Neals Drawings

$15000

Balance
$15000

7000

600

8000

9350
1300

8050

General Ledger
Accounts Receivable Account
Date

Explanation

Sep. 20

Service Revenue

Sep. 28

Cash

Ref.

Debit

Credit

$2000

Balance
$2000

600

1400

Supplies Account
Date

Explanation

Sep. 3

Accounts Payable

Sep. 28

Cash

Ref. Debit
$1600

Credit

Balance
$1600

General Ledger
Equipment Account
Date

Explanation

Sep. 2

Cash

Ref. Debit Credit Balance

$7000

$7000

Accounts Payable Account

Date

Explanation

Sep. 3

Supplies

Sep. 15

Advertising Expenses

Sep. 27

Cash

Ref. Debit

250

Credit Balance
$1600

$1600

250

1850
1600

General Ledger
Ray Neals Capital Account
Date

Explanation

Sep. 1

Cash

Ref. Debit

Credit
$15000

Balance
$15000

Ray Neals Drawings Account

Date

Explanation

Sep. 30

Cash

Ref. Debit
$1300

Credit

Balance
$1300

General Ledger
Service Revenue Account
Date Explanation
Ref. Debit Credit Balance
Sep. 10 Cash
$1200
$1200
Sep. 20 Cash
1500
2700
Sep. 20 Accounts Receivable
2000
4700
Advertising Expenses
Date

Explanation

Sep. 15

Accounts Payable

Ref.

Debit Credit Balance

$250

$250

General Ledger
Rent Expenses Account
Date

Explanation

Sep. 25

Cash

Ref.

Debit
$600

Credit

Balance
$600

Salaries Expenses Account

Date

Explanation

Sep. 25

Cash

Ref.

Debit
$900

Credit Balance
$900

Utility Expenses Account

Date

Explanation

Sep. 25

Cash

Ref.

Debit
$200

Credit Balance
$200

Trial Balance
Name of Accounts
Cash

Debit
Credit
$8050

Accounts Receivable

1400

Supplies

1600

Equipment

7000

Accounts Payable

$1600

Ray Neals Capital

15000

Ray Neals Drawing

1300

Service Revenue

4700

Advertisement Expenses

250

Rent Expenses

600

Salaries Expenses

900

Utilities Expenses

200

Total

$21300

$21300