"chapter 2 The Accounting SystemCopyright Barbara Chase/Corbis/AP Images Learning Goals •\t Understand the need for and general characteristics of a proper accounting system. •\t Understand accounts and how they are impacted by the debit/credit rules. •\t Know how to prepare journal entries to describe the effects of transactions and events. •\t Post accounts to the general ledger and prepare a trial balance. •\t Apply features and tools that are used to enhance and improve accounting systems and processes. waL80144_02_c02_027-052.indd 1 8/29/12 2:43 PMSection 2.1 System Design CHAPTER 2 Chapter Outline 2.1 System Design 2.2 Accounts and Debits/Credits Debit and Credit Rules T-Accounts 2.3 Transaction Analysis Critical Thinking About Transaction Analysis An Applied Example of Transaction Analysis 2.4 General Journal 2.5 Chart of Accounts Posting the General Ledger Trial Balance Review of the Sequence of Transaction Recording A Balanced Trial Balance: No Guarantee of Correctness Special Journals 2.6 Source Documents 2.7 Thinking About Automation 2.8 Critical Thinking About Debits and Credits xhibit 1.5 shows how transactions systematically impact the accounting equation andEresulting financial statements. Although this system works fine as an introduction tothe accounting equation, it is not adequate for managing an actual business. Too manytransactions originate in too many places for a single tabulation to capture all businessactivity reliably. Many small businesses have tried to use a simple schedule or spreadsheetto record and process all their activities; however, chaos quickly rules. A more completeand controlled accounting system is needed. 2.1 System Design arge and successful businesses have invariably developed robust accounting informa - Ltion systems. This suggests that the pathway to business success entails more thanjust product development and marketing. It also entails thoughtful development of well- designed accounting information systems. It is far better to establish a proper system atthe outset of launching a business, rather than coming back later and trying to repair aninadequate system. By the time a business discovers that its system is deficient, it is oftentoo late. The business may well have lost control of necessary information for proper busi - ness management. The results are often disastrous. This naturally leads you to wonder about the core elements of a proper system. Clearly,the accounting system must provide a basis for preparing financial statements. This is the28 waL80144_02_c02_027-052.indd 2 8/29/12 2:43 PMSection 2.2 Accounts and Debits/Credits CHAPTER 2 end objective and reflects the aggregation of all activity. Thus, the goal of an accountingsystem is to process transactions and events reliably into useful financial statements andreports. However, the system must also maintain retrievable documentation for everytransaction. An important feature is to allow a user to query the system for the purpose ofretrieving, verifying, or examining individual details of any specific business transaction. Computerized accounting systems summarize and interpret all business transactions. Theresult is useful financial data for purposes of investment and business management. Muchof the data input can actually originate with the transaction’s execution. For instance,while recording a customer’s purchase at a point-of-sale terminal, accounting records canbe updated to reflect the sale. This can additionally trigger adjustments of the company’sinventory records and even generate an order to a vendor to replace depleted stock onhand. While this level of sophistication can simplify the data entry process and increaseaccuracy of subsequent processing, it also entails considerable risk of “invisible” manipu - lation of data and file destruction. Thus, a good accounting system must take into consideration the need to control access,verify input, and back up essential records. Even with these important controls, a well- trained accountant must be knowledgeable and vigilant. A basic understanding of debits/ credits, journals, and other basic topics is essential to interpret computerized reports andspot errors that may have been inadvertently (or worse, deliberately) introduced into thesystem. Computerized accounting information systems are typically built around a databasestructure. This means that data are stored in an electronic array, including a variety ofdescriptive codes and indices. This coding process allows you to query the database toextract desired information instantaneously, based on parameters established by the per - son initiating the request of the accounting system. The long-standing structure of thecore financial statements and the basic tools used in their construction are generally pre - served in even the most sophisticated electronic environments. Indeed, it is difficult tounderstand or work within an automated accounting environment without first beingmoderately familiar and comfortable with the basic accounting tools. This chapter intr- o duces these important tools and helps you understand how they can be effectively usedto capture and process information. 2.2 Accounts and Debits/Credits n account is the master record that is maintained for each individual financial state - Ament asset, liability, equity, revenue, expense, or dividend component. Every finan - cial statement element (cash, accounts receivable, inventory, land, accounts payable, etc.)would have its own account and show the impact of all transactions causing a change tothat account. The collection of all accounts is known as the general ledger. Importantly, the collective balance of all accounts should conform to the accounting equa - tion, meaning that the sum of all asset accounts will equal the sum of all liability andequity components. Of course, in considering this equation, you need to be mindful thatthe revenue account increases equity and expenses and dividends decrease equity. 29 waL80144_02_c02_027-052.indd 3 8/29/12 2:43 PMSection 2.2 Accounts and Debits/Credits CHAPTER 2 Beginning students are typically mystified about how this equality is consistently pre - served. There is an answer to this, and the answer’s brilliance helps explain how the fun - damental accounting model has persevered for over 500 years. Indeed, that the modelcontinues to be programmed into today’s highly sophisticated computerized systemsspeaks volumes about the integrity of the model. The key ingredient is the concept ofdebits and credits. Debits and credits are often misunderstood. You may have had your account credited atthe bank, you might use a debit card to make a purchase, and you might prepare a creditapplication! The terms debit and credit are tossed around rather casually in day-to-dayactivities. At this point, the best thing to do is clear your mind of any meaning that youmight already associate with the terms and start anew. Debits and credits are account- ing tools, and you should focus on this important point: Every business transaction canbe described in terms of debit/credit impacts on specific accounts so that debits will always equalcredits. That is an amazing concept! By preserving this equality at the transaction level, the overallequality of the fundamental accounting equation is also preserved. You are perhaps skep - tical? Let’s look closer at this model. Debit and Credit Rules It is best to begin by memorizing certain “rules” about debits and credits. These rules arenot necessarily intuitive, but at least they are not hard to learn. Think of learning them inthe same way that you might memorize a few key words in a unfamiliar language, priorto taking a trip to a place where that is the only language spoken. Accountants and busi- nesspeople routinely speak about transactional effects in the context of debits and credits. Debit (often abbreviated “dr” and sometimes taken to mean “to record on the left-handside of an account,” as will become apparent shortly) is simply the action of recordingan increase to an asset, expense, or dividend account. Conversely, credit (abbreviated“cr” and sometimes taken to mean “to record on the right-hand side of an account”) isthe action of recording a decrease to those same accounts. For example, if Cash (an asset)is increased, we say that we are debiting cash. If Accounts Receivable (another asset) isdecreased, we say that we are crediting Accounts Receivable. Therefore, if a transactioninvolves collecting $1,000 cash from a customer who owes us the money (i.e., we have apreviously established account receivable on our balance sheet), then we simply say thatwe are debiting Cash and crediting Accounts Receivable for $1,000. By their nature, asset,expense, and dividend accounts usually have more debits than credits and are said tohave a normal debit balance (Exhibit 2.1). 30 waL80144_02_c02_027-052.indd 4 8/29/12 2:43 PMSection 2.2 Accounts and Debits/Credits CHAPTER 2 Exhibit 2.1: Assets, expenses, and dividend accounts Increased Decreased With Debits With Credits Assets Expenses Dividends Normal Balance Is Debit Liability, revenue, and equity accounts behave in an opposite fashion. They are increasedwith credits and decreased with debits. By their nature, these accounts usually have morecredits than debits and are said to have a normal credit balance (Exhibit 2.2). Table 2.1 listsmany typical accounts, showing the application of the debit and credit rules. Exhibit 2.2: Liability, revenue, and equity accounts Decreased Increased With Debits With Credits Liabilities Revenues Equity Normal Balance Is Credit 31 waL80144_02_c02_027-052.indd 5 8/29/12 2:43 PMSection 2.2 Accounts and Debits/Credits CHAPTER 2 Table 2.1: Schedule of debit and credit rules for typical accounts Normal Balance Increased With Decreased With Typical Assets Cash Accounts Receivable Inventory Debit Debit Credit Land Buildings Equipment Typical Liabilites Accounts Payable Salaries Payable Credit Credit Debit Notes and LoansPayable Typical Equites Capital Stock Credit Credit Debit Retained Earnings Typical Revenues Service Revenue Credit Credit Debit Sales Typical Expenses Salaries and Wages Utlites Interest Debit Debit Credit Rent Supplies Taxes Dividends Dividends Debit Debit Credit In addition to the preceding rules, a few select accounts are known as contra accounts.You will be exposed to these accounts in future chapters related to accounts receivable,plant assets, and certain long-term indebtedness. A contra account is an offset to anotheraccount and has opposite debit and credit rules. For example, the wear and tear on a plantasset via the passage of time can result in a reduction in the asset’s reported cost. Thisimpact is reflected as accumulated depreciation, which is netted against (i.e., reportedas contra to) the plant asset. Thus, the accumulated depreciation is reported within theasset section but has opposite debit and credit rules (e.g., increased with a credit and viceversa). This concept will be covered in more sufficient depth later. 32 waL80144_02_c02_027-052.indd 6 8/29/12 2:43 PMSection 2.3 Transaction Analysis CHAPTER 2 T-Accounts No introduction to accounting would be complete without mentioning T-accounts. AT-account is not part of an accounting system; it is only a device that is used to demon - strate the impact of certain transactions and events. T-accounts are useful teaching toolsand are also used by accountants also use them when chatting about accounting effects.You can think of T-accounts as accounting on a napkin. A T-account is shaped like a “T,”with debits on the left and credits on the right. Exhibit 2.3 illustrates T-accounts show - ing the effects of purchasing $50,000 of equipment for $10,000 cash and a $40,000 notepayable. In this case, Equipment (an asset) is increased via the debit; Cash (an asset) isdecreased via the credit the credit; and Note Payable (a liability) is increased with a credit. Exhibit 2.3: T-accounts The only limit to what can be illustrated within T-accounts is the size of the paperon which they are drawn. Exhibit 2.4 shows a T-account for Cash corresponding to allactivity that impacted this particular account (transactions are assumed for the sake ofthis illustration until later in this text). Notice that the excess of debits over creditsequals the ending cash balance. Later in this chapter, you will see a comprehensiveexample for Clearview Window Washers, and this particular T-account willcorrespond to the cash transactions described therein. Exhibit 2.4: Sample T-account for Cash 2.3 Transaction Analysis he process of maintaining accountability over a business’s affairs begins with an anal - Tysis of each transaction. You must determine what accounts are impacted and howthey are impacted (increased or decreased). These increase/decrease impacts are thentranslated into the accounting language of debits and credits. You may be wondering whyit is not possible to just use increase and decrease to describe effects on accounts. Simplyput, increases will not always equal decreases. 33 waL80144_02_c02_027-052.indd 7 8/29/12 2:43 PMSection 2.3 Transaction Analysis CHAPTER 2 For example, if one purchased inventory (an asset) with an account payable (a liability),both sides of the balance sheet increase. In other words, Cash increases on the asset side,and Accounts Payable increases on the liability side. When converted to debit/credit con- sequence, the same transaction is described as a debit to Cash (assets are increased withdebits) and a credit to Accounts Payable (liabilities are increased with credits). Identifyinga transaction where debits do not appropriately equal credits is impossible. Conversely, itis possible to identify a mishmash of transactions that display every conceivable combina- tion of increases and decreases, some of which are offsetting and others that are not. Is itstarting to make sense why accountants stick with debit and credit nomenclature? Critical Thinking About Transaction Analysis Perhaps one of the more frustrating parts of learning accounting is developing the skillsnecessary to evaluate transactions and describe the debit/credit impacts on all affectedaccounts. This is akin to learning a new language. For most people, practice and repetitionis required. If you try to skip over this part of the learning process, you will find yourselfincreasingly frustrated with future chapters. Table 2.2 is not exhaustive but is intended toprovide you with some added guidance and practice in transaction analysis. Table 2.2: Transacton analysis Example Transactons Critcal Thinking Conclusion Provide services Cash, an asset, and Revenues are both Debit Cash. for cash. increased. Credit Revenues. Provide services Accounts Receivable, an asset, and Revenues Debit Accounts Receivable. on account. are both increased. Credit Revenues. Pay an expense Expenses are increased and Cash, an asset, Debit Expense. with cash. is decreased. Credit Cash. Incur an expense Expenses and Accounts Payable, a liability, Debit Expense. on account. are both increased. Credit Accounts Payable. Buy an asset for cash. The\tspecifc \tasse t\t pur chased \tis \tincr eased, \t Debit Asset. and Cash, an asset, is decreased. Credit Cash. Buy an asset The\tspecifc \tasse t\t pur chased \tand \tLoan\t Debit Asset. with debt. Payable, a liability, are both increased. Credit Loan Payable. Collect an account. Cash, an asset, is increased, and Accounts Debit Cash. Receivable, an asset, is decreased. Credit Accounts Receivable. Pay an account. Cash, an asset, and Accounts Payable, a Debit Accounts Payable. liability, are both decreased. Credit Cash. Borrow cash. Cash, an asset, and Loan Payable, a liability, Debit Cash. are both increased. Credit Loan Payable. Issue stock for cash. Cash, an asset, and Capital Stock, an equity Debit Cash. account, are both increased. Credit Capital Stock. Pay a dividend. Dividends are increased and Cash, an asset, Debit Dividends. is decreased. Credit Cash. 34 waL80144_02_c02_027-052.indd 8 8/29/12 2:43 PMSection 2.3 Transaction Analysis CHAPTER 2 An Applied Example of Transaction Analysis To reiterate these important concepts, let’s revisit the example from Chapter 1 (see Table1.2). This time, however, the table is expanded to include an extra column showing thedebit and credit impacts (Table 2.3). Spend some quality time thinking about each trans- action and how the proposed debit and credit impacts tie in to the debit and credit rules. Table 2.3: Debit and credit impacts Descripton Amount Discussion of How Balance Is Debit 5 CreditMaintained Translaton Provided window- $ 10,000 Cash (an asset) and Revenues both Cash, an asset, is increased with aincrease; revenues increase income debit 5 Revenue is increased withwashing services which increases equity. a credit for cash. $ 30,000 The asset, Accounts Receivable Accounts Receivable, an asset, isProvided services(r e pr esen tng\tamoun ts\tdue \tfr om\t increased with a debit 5 Revenueon account tocustomers for work already rendered) is increased with a credit customers. is increased, which is matched with anincrease in Revenues/Income/Equity. $ 20,000 Cash is increased and Accounts Cash, an asset, is increased with aCollectedR eceiv able\tis\tde cr eased,\tr esultng\tin\tno \t debit 5 Accounts Receivable, anamounts due fromchange in total assets. asset, is decreased with a credit customers forwork previouslyrendered. Used up supplies $3,000 An\te xis tng\tasse t, \tSupplie s,\tis\tuse d\tup \t Supplies Expense, an expense, isand must be removed from the Asset increased with a debit 5 Supplies,in the process ofaccount. This represents an Expense an asset, is decreased with a credit providing services(expenses decrease income andto customers. therefore equity). Bought additonal $ 2,500 Supplies increase, as does the Accounts Supplies, an asset, is increasedsupplies on Payable liability account. with a debit 5 Accounts Payable, aliability, is increased with a Credit account. Paid amounts due $ 6,000 Cash and Accounts Payable are both Accounts Payable, a liability, isdecreased. decreased with a debit 5 Cash, anon outstandingasset, is decreased with a credit Accounts Payable. Issued additonal $12,000 Cash and the Capital Stock account are Cash, an asset, is increased withshares of stock. both increased by the same amount. a debit 5 Capital Stock, an equityaccount, is increased with a credit $75,000 Land (an asset) goes up by $75,000. Land, an asset, is increased withPurchased land This\tis\tof se t\ta\t$20,000\tr educton\t a debit for $75,000 5 Cash, anfor cash ($20,000)in Cash. The balancing amount of asset, is decreased with a creditand incurred a$55,000\tis\tr e fect ed\tas\tincr ease\tin\tthe\t for $20,000, and Loan Payable, a$55,000 loan. liability account Loan Payable. liability, is increased with a Creditfor $55,000 Paid wages to $ 7,000 Cash is decreased, as is Income/Equity Wage Expense, an expense, isvia the recording of Wages Expense. increased with a debit 5 Cash, anemployees. asset, is decreased with a credit Paid dividends to $5,000 Cash is decreased and the Dividends Dividends are increased withshareholders. account is increased by the same a debit 5 Cash, an asset, isamount (which causes a decrease in decreased with a credit Retained Earnings/Equity). 35 waL80144_02_c02_027-052.indd 9 8/29/12 2:43 PMSection 2.3 Transaction Analysis CHAPTER 2 You might have noticed that some transactions can impact more than just two accounts.This example included the purchase of land for cash and a loan payable. Nevertheless,these compound entries are still expected to balance. Exhibit 2.5 is a repeat of Exhibit 1.5but revised to reflect debits and credits in lieu of pluses and minuses. Carefully note thatdebits equal credits within each row. Exhibit 2.5: Spreadsheet for Clearview WindowWashers for December 36 waL80144_02_c02_027-052.indd 10 8/29/12 2:43 PM Assets =+ Liabilities Stockholders’ Equity Description Cash Accounts Supplies Land Accounts Loan Capital Dividends Revenues Expenses (decrease (increase (decrease Receivable payable payable stock income, thus income, thus (increase equity) equity) equity) equity) Retained Earnings Beginning balances $ 50,000 $125,000 $ 5,000 $20,000 $ 8,000 $ 2,000 $50,000 $140,000 Services for cash Dr 10,000 Cr 10,000 Services on account Dr 30,000 Cr 30,000 Collect account Dr 20,000 Cr (20,000) Dr3,000 Record use of supplies Cr (3,000) Buy supplies on account Dr 2,500 Cr 2,500 Pay on account Cr (6,000) Dr (6,000) Additional investment Dr 12,000 Cr 12,000 Buy land with Cr (20,000) Dr 75,000 Cr 55,000 cash and loan Dr7,000 Pay wages Cr (7,000) Dividends Cr (5,000) – – – – – – Dr 5,000 – – Ending balance $ 54,000 $135,000 $ 4,500 $ 95,000 $ 4,500 $ 57,000 $62,000 $ 5,000 $40,000 $10,000 $30,000 Net Income $30,000 – $5,000 = $25,000 Increase in retained earnings Plus beginning retained earnings Ending retained earnings $288,500 $61,500 $227,000 Total Assets Total Liabilities Total Equity"