Accounting - Chapter 2 Notes
LEARNING OBJECTIVES
CONCEPTUAL
1. C1Explain the steps in processing transactions and the role of source documents.
2. C2Describe an account and its use in recording transactions.
3. C3Describe a ledger and a chart of accounts.
4. C4Define debits and credits and explain double-entry accounting.
ANALYTICAL
1. A1Analyze the impact of transactions on accounts and financial statements.
2. A2Compute the debt ratio and describe its use in analyzing financial condition.
PROCEDURAL
1. P1Record transactions in a journal and post entries to a ledger.
2. P2Prepare and explain the use of a trial balance.
3. P3Prepare financial statements from business transactions.
SYSTEM OF ACCOUNTS
C1
Explain the steps in processing transactions and the role of source
documents.
Business transactions and events are the starting points of financial
statements. The process to get from transactions and events to financial
statements includes the following:
 Identify each transaction and event from source documents.
 Analyze each transaction and event using the accounting equation.
 Record relevant transactions and events in a journal.
 Post journal information to ledger accounts.
 Prepare and analyze the trial balance and financial statements.
Source Documents
Source documents identify and describe transactions and events entering
the accounting system. They can be in either hard copy or electronic
form. Examples are sales tickets, checks, purchase orders, bills from
suppliers, employee earnings records, and bank statements. For example,
cash registers record information for each sale on a tape or electronic file
locked inside the register. This record is a source document for recording
sales in the accounting records. Source documents are objective and
reliable evidence about transactions and events and their amounts.
Point: Accounting records are informally referred to as the accounting books, or simply the books.
The Account and Its Analysis
C2
Describe an account and its use in recording transactions.
An account is a record of increases and decreases in a specific asset,
liability, equity, revenue, or expense. The general ledger, or
simply ledger,is a record of all accounts used by a company. The ledger is
often in electronic form. While most companies’ ledgers contain similar
accounts, a company often uses one or more unique accounts because of its
type of operations. An unclassified balance sheet broadly groups
accounts into assets, liabilities, and equity. Exhibit 2.1 shows typical asset,
liability, and equity accounts
EXHIBIT 2.1 Accounts Organized by the Accounting Equation
Asset Accounts
Assets are resources owned or controlled by a company, and those
resources have expected future benefits. Most accounting systems include
(at a minimum) separate accounts for the assets described here.
Cash
A Cash account reflects a company’s cash balance. All increases and
decreases in cash are recorded in the Cash account. It includes money and
any funds that a bank accepts for deposit (coins, checks, money orders, and
checking account balances).
Accounts Receivable
Accounts receivable are held by a seller and refer to promises of payment
from customers to sellers. These transactions are often called credit
sales or sales on account (or on credit). Accounts receivable are increased
by credit sales and billings to customers but are decreased by customer
payments. We record all increases and decreases in receivables in the
Accounts Receivable account. When there are multiple customers, separate
records are kept for each, titled Accounts Receivable—‘Customer Name’.
Point: Customers and others who owe a company are called its debtors
Note Receivable
A note receivable, or promissory note, is a written promise of another entity
to pay a specific sum of money on a specified future date to the holder of
the note; the holder has an asset recorded in a Note (or Notes) Receivable
account.
Prepaid Accounts
Prepaid accounts (also called prepaid expenses) are assets that represent
prepayments of future expenses (expenses expected to be incurred in one or
more future accounting periods). When the expenses are later incurred, the
amounts in prepaid accounts are transferred to expense accounts. Common
examples of prepaid accounts include prepaid insurance, prepaid rent, and
prepaid services (such as club memberships). Prepaid accounts expire with
the passage of time (such as with rent) or through use (such as with prepaid
meal tickets). When financial statements are prepared (1) all expired and
used prepaid accounts are recorded as expenses and (2) all unexpired and
unused prepaid accounts are recorded as assets (reflecting future use in
future periods). To illustrate, when an insurance fee, called a premium, is
paid in advance, the cost is typically recorded in the asset
account titled Prepaid Insurance. Over time, the expiring portion of the
insurance cost is removed from this asset account and reported in expenses
on the income statement. Any unexpired portion remains in Prepaid
Insurance and is reported on the balance sheet as an asset.
Point: A college parking pass is a prepaid account from the student’s standpoint. At the beginning of the term, it is
an asset that entitles a student to park on or near campus. The benefits of the parking pass expire as the term
progresses. At term-end, prepaid parking (asset) equals zero as it has been entirely recorded as parking expense.
Supplies Accounts
Supplies are assets until they are used. When they are used up, their costs
are reported as expenses. The costs of unused supplies are recorded in a
Supplies asset account. Supplies are often grouped by purpose—for
example, office supplies and store supplies. Office supplies include paper,
toner, and pens. Store supplies include packaging and cleaning materials.
Equipment Accounts
Equipment is an asset. When equipment is used and gets worn down, its
cost is gradually reported as an expense (called depreciation). Equipment is
often grouped by its purpose—for example, office equipment and store
equipment. Office equipment includes computers and desks. The Store
Equipment account includes counters and cash registers.
Buildings Accounts
Buildings such as stores, offices, warehouses, and factories are assets
because they provide expected future benefits to those who control or own
them. Their costs are recorded in a Buildings asset account. When several
buildings are owned, separate accounts are sometimes kept for each of
them.
Point: Some assets are described as intangible because they do not have physical existence or their benefits are
highly uncertain. A recent balance sheet for Coca-Cola Company shows nearly $15 billion in intangible
assets.
Land
The cost of land owned by a business is recorded in a Land account. The
cost of buildings located on the land is separately recorded in one or more
building accounts.
Liability Accounts
Liabilities are claims (by creditors) against assets, which means they are
obligations to transfer assets or provide products or services to
others. Creditors are individuals and organizations that have rights to
receive payments from a company. Common liability accounts are described
here.
Point: If a company fails to pay its obligations, the law gives creditors a right to force the sale of that company’s
assets to obtain money to meet creditors’ claims.
Accounts Payable
Accounts payable refer to promises to pay later, which usually arise from
purchases of merchandise for resale. Payables can also arise from
purchases of supplies, Page 56equipment, and services. We record all
increases and decreases in payables in the Accounts Payable account. When
there are multiple suppliers, separate records are kept for each, titled
Accounts Payable—‘Supplier Name’.
Point: Accounts payable are also called trade payables.
Note Payable
A note payable refers to a formal promise, usually indicated by the signing
of a promissory note, to pay a future amount. It is recorded in either a
short-term Note Payable account or a long-term Note Payable account,
depending on when it must be repaid. We explain details of short- and longterm classification in the next two chapters.
Unearned Revenue Accounts
Unearned revenue refers to a liability that is settled in the future when a
company delivers its products or services. When customers pay in advance
for products or services (before revenue is earned), the seller considers this
receipt as unearned revenue. Examples of unearned revenue include
magazine subscriptions collected in advance by a publisher, rent collected
in advance by a landlord, and season ticket sales by sports teams. The seller
would record these in liability accounts such as Unearned Subscriptions,
Unearned Rent, and Unearned Ticket Revenue. When products and services
are later delivered, the earned portion of the unearned revenue is
transferred to revenue accounts such as Subscription Fees Revenue, Rent
Revenue, and Ticket Revenue.1
Point: Two words that almost always identify liability accounts: “payable” meaning liabilities that must be paid,
and “unearned” meaning liabilities that must be fulfilled.
Accrued Liabilities
Accrued liabilities are amounts owed that are not yet paid. Examples are
wages payable, taxes payable, and interest payable. These are often
recorded in separate liability accounts by the same title. If they are not
large in amount, one or more ledger accounts can be added and reported as
a single amount on the balance sheet. (Financial statements often have
amounts reported that are a summation of several ledger accounts.)
Equity Accounts
The owner’s claim on a company’s assets is called equity or owner’s
equity. Equity is the owner’s residual interest in the assets of a business
after deducting liabilities. Equity is impacted by four types of accounts as
follows:
Equity = Owner’s capital - Owner’s withdrawals + Revenues -
Expenses.
We show this visually in Exhibit 2.2 by expanding the accounting equation.
We also organize assets and liabilities into subgroups that have similar
attributes. An important subgroup for both assets and liabilities is
the current items. Current items are usually those expected to come due
(either collected or owed) within the next year. The next two chapters
explain this in detail. At this point, know that a classified balance
sheet groups accounts into classifications (such as land and buildings into
Plant Assets) and it reports current assets before noncurrent assets and
current liabilities before noncurrent liabilities.
EXHIBIT 2.2 Accounts Classified by the Expanded Accounting Equation
Owner Capital
When an owner invests in a company, it increases both assets and equity.
The increase to equity is recorded in an account titled Owner,
Capital (where the owner’s name is inserted in place of “Owner”). The
account titled C. Taylor, Capital is used for FastForward. Any owner
investments are recorded in this account.
Point: The Owner’s Withdrawals account is a contra equity account because it reduces the normal balance of
equity.
Page 57
Owner Withdrawals
When an owner withdraws assets for personal use, it decreases both
company assets and total equity. The decrease to equity is recorded in an
account titled Owner, Withdrawals. The account titled C. Taylor,
Withdrawals is used for FastForward. Withdrawals are not expenses of the
business; they are simply the opposite of owner investments. (Owners of
proprietorships cannot receive company salaries because they are not
legally separate from their companies; and they cannot enter into company
contracts with themselves.)
Point: The withdrawal of assets by the owners of a corporation is called a dividend.
Revenue Accounts
The inflow of net assets from providing products and services to customers
increases equity through increases in revenue accounts. Examples of
revenue accounts are Sales, Commissions Earned, Professional Fees
Earned, Rent Revenue, and Interest Revenue. Revenues always increase
equity.
Expense Accounts
The outflow of net assets in helping generate revenues decreases equity
through increases in expense accounts. Examples of expense accounts are
Advertising Expense, Store Supplies Expense, Office Salaries Expense,
Office Supplies Expense, Rent Expense, Utilities Expense, and Insurance
Expense. Expenses always decrease equity. The variety of revenues and
expenses can be seen by looking at the chart of accounts that follows the
index at the end of this book. (Different companies sometimes use different
account titles than those in this book’s chart of accounts. For example, some
might use Interest Revenue instead of Interest Earned, or Rental Expense
instead of Rent Expense. It is important only that an account title describe
the item it represents.)
Ledger and Chart of Accounts
C3
Describe a ledger and a chart of accounts.
The collection of all accounts and their balances for an accounting system is
called a ledger (or general ledger). A company’s size and diversity of
operations affect the number of accounts needed. A small company can get
by with as few as 20 or 30 accounts; a large company can Page 58require
several thousand. The chart of accounts is a list of all ledger accounts and
includes an identification number assigned to each account. Exhibit
2.3 shows a common numbering system of accounts for a smaller business.
EXHIBIT 2.3 Typical Chart of Accounts for a Smaller Business
These account numbers provide a three-digit code that is useful in recordkeeping.
In this case, the first digit assigned to asset accounts is a 1, the first digit assigned
to liability accounts is a 2, and so on. The second and third digits relate to the
accounts’ subcategories.
FastForward, the focus company of  | shows a partial chart of accounts for
. (A more complete chart of accounts
Exhibit 2.4
Chapter 1follows the index at the end of this book.
EXHIBIT 2.4 Partial Chart of Accounts for FastForward
Chart of Accounts

DOUBLE-ENTRY ACCOUNTING
This section explains the structure of double-entry accounting, including
debits and credits.
Debits and Credits
C4
Define debits and credits and explain double-entry accounting.
A T-account represents a ledger account and is used to depict the effects of
one or more transactions. Its name comes from its shape like the
letter T.The layout of a T-account, shown in Exhibit 2.5, is (1) the account
title on top; (2) a left, or debit, side; and (3) a right, or credit, side.
EXHIBIT 2.5 The T-Account
Account Title
(Left side)
Debit
(Right side)
Credit
The left side of an account is called the debit side, often abbreviated Dr.
The right side is called the credit side, abbreviated Cr.2 To enter amounts
on the left side of an account is to debit the account. To enter amounts
on Page 59the right side is to credit the account. The term debit or credit, by
itself, does not mean increase or decrease. Whether a debit or a credit is an
increase or decrease depends on the account.
The difference between total debits and total credits for an account,
including any beginning balance, is the account balance. When the sum of
debits exceeds the sum of credits, the account has a debit balance. It has
a credit balance when the sum of credits exceeds the sum of debits. When
the sum of debits equals the sum of credits, the account has a zero balance.
Point: Think of debit and credit as accounting directions for left and right
Double-Entry System
Double-entry accounting demands the accounting equation remain in
balance, which means that for each transaction:
 At least two accounts are involved, with at least one debit and one
credit.
 The total amount debited must equal the total amount credited.
This means the sum of the debits for all entries must equal the sum of the
credits for all entries, and the sum of debit account balances in the ledger
must equal the sum of credit account balances. The system for recording
debits and credits follows from the accounting equation—see Exhibit 2.6.
EXHIBIT 2.6 Debits and Credits in the Accounting Equation
First, net increases or decreases on one side have equal net effects on the
other side. For example, a net increase in assets must be accompanied by
an identical net increase on the liabilities and equity side. Recall that some
transactions affect only one side of the equation, such as acquiring a land
asset by giving up a cash asset, but their net effect on this one side is zero.
Second, the left side is the normal balance side for assets, and the right side
is the normal balance side for liabilities and equity. This matches their
layout in the accounting equation, where assets are on the left side of this
equation and liabilities and equity are on the right.
Point: Assets are on the left-hand side of the equation and thus increase on the left. Liabilities and Equity are on
the right-hand side of the equation and thus increase on the right.
Third, equity increases from revenues and owner investments and it
decreases from expenses and owner withdrawals. These important equity
relations are conveyed by expanding the accounting equation to include
debits and credits in double-entry form as shown in Exhibit 2.7.
EXHIBIT 2.7 Debit and Credit Effects for Component Accounts
Fourth, increases (credits) to owner’s capital and revenues increase equity;
increases (debits) to withdrawals and expenses decrease equity. The normal
balance of each account (asset, liability, capital, withdrawals, revenue, or
expense) refers to the side where increases are recorded.
Point: Debits and credits do not mean favorable or unfavorable. A debit to an asset increases it, as does a debit to
an expense. A credit to a liability increases it, as does a credit to a revenue.
The T-account for FastForward’s Cash account, reflecting its first 11
transactions (from Exhibit 1.9), is shown in Exhibit 2.8. The total
increases (debits) in its Cash account are $36,100, and the total decreases
(credits) are $31,300. Total debits exceed total credits by $4,800, resulting
in its ending debit balance of $4,800.
EXHIBIT 2.8 Computing the Balance for a T-Account
ANALYZING AND PROCESSING TRANSACTIONS
This section explains the analzying, recording, and posting of transactions.
Journalizing and Posting Transactions
P1
Record transactions in a journal and post entries to a ledger.
The four steps of processing transactions are depicted in Exhibit 2.9. Steps
1 and 2—involving transaction analysis and the accounting equation—were
already discussed. This section extends that discussion and focuses on steps
3 and 4 of the accounting process. Step 3 is to record each transaction
chronologically in a journal. A journal gives a complete record of each
transaction in one place. It also shows debits and credits for each
transaction.The process of recording transactions in a journal is
called journalizing. Step 4 is to transfer (or post) entries from the journal
to the ledger. The process of transferring journal entry information to the
ledger is called posting.