Chapter 4: How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?

The Nature of a Transaction

Question: Information provided by a set of financial statements is essential to any individual analyzing a business or other organization. The availability of a fair representation of a company’s financial position, operations, and cash flows is invaluable for a wide array of decision makers. However, the sheer volume of data that a business such as General Mills, McDonald’s, or PepsiCo must gather in order to prepare these statements has to be astronomical. Even a small enterprise—a local convenience store, for example—generates a significant quantity of information virtually every day. How does an accountant begin the process of accumulating all the necessary data so that financial statements can be produced and distributed to decision makers?

Answer: The accounting process starts by analyzing the effect of transactionsEvents that have a financial impact on an organization; information on the resulting changes must be gathered, sorted, classified, and turned into financial statements by means of an accounting system.—any event that has an immediate financial impact on a company. Large organizations participate in literally millions of transactions each year. The resulting information must be gathered, sorted, classified, and turned into a set of financial statements that cover a mere four or five pages. Over the decades, accountants have had to become very efficient to fulfill this seemingly impossible assignment. Despite the volume of transactions, the goal remains the same: to prepare financial statements that are presented fairly because they contain no material misstatements according to U.S. GAAP or IFRS.

For example, all the occurrences listed in Figure 4.1 “Transactions Frequently Encountered by a Business” are typical transactions that any business might encounter. Each causes some measurable effect on the company’s assets, liabilities, revenues, expenses, gains, losses, capital stock, or dividends paid. The accounting process begins with an analysis of each transaction to determine the specific financial changes that took place. Was revenue earned? Did a liability increase? Has an asset been acquired? What changed as a result of this event?

Figure 4.1 Transactions Frequently Encountered by a Business

In any language, successful communication is only possible if the information to be conveyed is properly understood. Likewise, in accounting, transactions must be analyzed so that their impact is understood. A vast majority of transactions are relatively straightforward so that, with experience, the accountant can ascertain the financial impact almost automatically. Within this process, each individual asset, liability, revenue, expense, and the like is referred to as an account. For example, rent expense and salary expense are both expense accounts. The monetary amount attributed to an account is known as an account balance.

For transactions with greater complexity, the necessary analysis becomes more challenging. However, the importance of this initial step in the production of financial statements cannot be overstressed. The well-known computer aphorism captures the essence quite succinctly: “garbage in, garbage out.” There is little hope that financial statements can be fairly presented unless the entering information is based on an appropriate identification of the changes in account balances created by each transaction.

Analyzing the Impact of a Transaction

Question: Transaction 1—A company buys inventory on credit for $2,000. How does transaction analysis work here? What accounts are affected by the purchase of merchandise?

Answer: Inventory, which is an asset, increases by $2,000 because of the purchase. The organization has more inventory than it did previously. Because no money was paid for these goods when bought, a liability for the same amount has been created. The term accounts payableShort-term liabilities to pay for goods and services that have been acquired on credit. is often used in financial accounting to represent debts resulting from the acquisition of inventory and supplies.

Note that the accounting equation described in the previous chapter remains in balance here. Assets have gone up by $2,000 while the liability side of the equation has also increased by the same amount to reflect the source of this increase.

The Financial Impact of Paying an Employee

Question: Transaction 2—A company pays a salary of $300 to one of its employees for work performed during the past week. No amount had previously been recorded by the accounting system for this amount. What accounts are affected by payment of a salary?

Answer: Cash (an asset) is decreased here by $300. Whenever cash is involved in a transaction, identifying that change is a good place to start the analysis. Increases and decreases in cash are often obvious.

The cash balance declined because salary was paid to an employee. Assets were reduced as a result of the payment. That is a cost to the company. Recognizing an expense as a result is appropriate rather than an asset because the employee’s work reflects a past benefit. The person’s effort has already been carried out, generating revenues for the company in the previous week rather than in the future. Thus, a salary expense of $300 is reported.

The continued equilibrium of the accounting equation does exist here although it is less apparent. Assets are decreased. At the same time, an expense is recognized. This expense reduces reported net income. On the statement of retained earnings, current net income becomes a component of retained earnings. The reduction in income serves to decrease retained earnings. An expense ultimately reduces reported retained earnings. Because both assets and retained earnings go down by the same amount as a result of this transaction, the accounting equation continues to balance.

Recording Accrued Expenses

Question: In Transaction 2, the company paid a salary of $300 that it owed to a worker. Why does a payment to an employee not always reduce a salary payable balance?

Answer: Costs such as salary, rent, or interest increase gradually over time and are often referred to as accrued expenses because the term “accrue” means “to grow.” How should the very slow growth of an expense be recognized? An accounting system can be mechanically structured to record such costs in either of two ways. On the financial statements, reported results are the same but the steps in the process differ.

• Some companies simply ignore accrued expenses until paid. At that time, the expense is recognized and cash is reduced. No liability is entered into the accounting system or removed. Because the information provided specifies that nothing has been recorded to date, this approach was apparently used here. When financial statements are produced, any amount that is still owed must be recognized for a fair presentation.
• Other companies choose to program their computer systems so that both the expense and the related liability are recognized automatically as the amount grows. For salary, as an example, this increase could literally be recorded each day or week based on the amount earned by employees. At the time payment is finally conveyed, the expense has already been recorded. Thus, the liability is removed because that debt is being settled. Later, in Transaction 5, this second possible approach to recording accrued expenses is illustrated.

A company can recognize an accrued expense (such as a salary) as it is incurred or wait until payment is made. This decision depends on the preference of company officials. The end result (an expense is reported and cash decreased) is the same, but the recording procedures differ. As mentioned, if no entry has been made prior to the production of financial statements (the first alternative), both the expense and the payable have to be recognized at that time so that all balances are properly included for reporting purposes.

Borrowing Money from the Bank

Question: Transaction 3—A company borrows $9,000 from a bank on a long-term note. What is the financial impact of signing a loan agreement with a bank or other lending institution?

Answer: In this transaction, cash is increased by the amount of money received from the lender. The company is obligated to repay this balance and, thus, has incurred a new liability. As with many common transactions, the financial impact is reasonably easy to ascertain.

Recording the Sale of Inventory

Question: Transaction 4—Assume that the inventory items bought in Transaction 1 for $2,000 are now sold to a customer for $5,000 on credit. What account balances are impacted by the sale of merchandise in this manner?

Answer: Two connected events actually take place in the sale of inventory. First, revenue of $5,000 is generated by the sale. This account is frequently labeled as “Sales” or “Sales revenue.”

In this example, because the money will not be collected until a later date, accounts receivable (an asset) is initially increased. The reporting of a receivable balance indicates that this amount of money is due from a customer and should be collected at some subsequent point in time.

Second, the inventory is removed. Companies have an option in the method by which inventory balances are monitored. Here, a perpetual inventory systemAccounting system that maintains an ongoing record of all inventory items both in total and individually; records increases and decreases in inventory accounts as they occur as well as the cost of goods sold to date. is utilized. That approach is extremely common due to the prevalence of computer systems in the business world. It maintains an ongoing record of the inventory held and the amount that has been sold to date. All changes in inventory are recorded immediately. However, in a later chapter, an alternative approach—still used by some smaller businesses—known as a periodic inventory systemAccounting system that does not maintain an ongoing record of all inventory items; instead, ending inventory is determined by a physical count so that a formula (beginning inventory plus purchases less ending inventory) can be used to calculate cost of goods sold. will also be demonstrated.

Because a perpetual system is used here, the reduction in inventory is recorded simultaneously with the sale. Inventory costing $2,000 is taken away by the customer. The company’s net assets are reduced by this amount. Therefore, a $2,000 expense is recognized. That inventory no longer provides a future benefit for the company but rather is a past benefit. Cost of goods sold is reported to reflect this decrease in the amount of merchandise on hand.

As discussed in the previous chapter, the $3,000 difference between the sales revenue of $5,000 and the related cost of goods sold of $2,000 is known as the gross profit (or gross margin or mark up) on the sale.

The Dual Effect of Transactions

Question: In each of the events studied so far, two accounts have been affected. Are two accounts impacted by every possible transaction?

Answer: In every transaction, a cause-and-effect relationship is always present. For example, the accounts receivable balance increases because of a sale. Cash decreases as a result of paying salary expense. Cost of goods sold increases because inventory is removed. No account balance can possibly change without some identifiable cause. Thus, every transaction must touch a minimum of two accounts. Many transactions actually affect more than two accounts but at least two are impacted by each of these financial events.

Paying a Previously Recorded Expense

Question: Transaction 5—In this transaction, the reporting company pays $700 for insurance coverage relating to the past few months. The information provided indicates that the cost was previously recorded in the company’s accounting system as incurred. Apparently, the computers were programmed to accrue this expense periodically. What is the financial impact of paying an expense if the balance has already been recognized over time as the liability grew larger?

Answer: Several pieces of information should be noted in analyzing this example.

• Cash declined by $700 as a result of the payment.
• This cost relates to a past benefit. Thus, an expense must be recorded. No future economic benefit is created by the insurance payment. Cash was paid for coverage over the previous months.
• The company’s accounting system has already recorded this amount. Thus, $700 in insurance expense and the related liability were recognized as incurred. This is clearly a different mechanical procedure than that demonstrated in Transaction 2 for the salary payment.

The expense cannot be recorded again or it will be double counted. Instead, cash is reduced along with the liability that was established through the accrual process. The expense was recorded already so no additional change in that balance is needed. Instead, the liability is removed and cash decreased.

Note that accounting recognition is dependent on the recording that has already taken place. The final results to be reported should be the same (here an expense is recognized and cash decreased), but the steps in the process can vary.

Acquisition of an Asset

Question: Transaction 6—According to the original information, a truck is acquired for $40,000, but only $10,000 in cash is paid by the company. The other $30,000 is covered by signing a note payable. This transaction seems a bit more complicated because more than two accounts are involved. What is the financial impact of buying an asset when only a portion of the cost is paid on that date?

Answer: In this transaction, for the first time, three accounts are impacted. A truck is bought for $40,000 so the balance recorded for this asset is increased by that cost. Cash decreases $10,000 while the notes payable balance rises by $30,000. These events each happened. To achieve a fair presentation, the accounting process seeks to reflect the actual occurrences that took place. As long as the analysis is performed properly, recording a transaction is no more complicated when more than two accounts are affected.

Recording a Capital Contribution by an Owner

Question: Transaction 7—Assume that several individuals approach the company and offer to contribute $19,000 in cash to the business in exchange for capital stock so that they can join the ownership. The offer is accepted. What accounts are impacted by the issuance of capital stock to the owners of a business?

Answer: When cash is contributed to a company for a portion of the ownership, cash obviously goes up by the amount received. This money was not generated by revenues or by liabilities but rather represents assets given freely so that new ownership shares could be obtained. This inflow is reflected in financial accounting as increases in both the cash and capital stock accounts. Outside decision makers can see that this amount of the company’s net assets came from investments made by owners.

The Collection of an Account Receivable

Question: Transaction 8—A sale of merchandise was made previously in Transaction 4 for $5,000. No cash was received at that time, but the entire amount is collected now. What accounts are affected by the receipt of money from an earlier sale?

Answer: The revenue from this transaction was properly recorded in Transaction 4 when the sale originally took place and the account receivable balance was established. Revenue should not be recorded again or it will be double counted, causing reported net income to be overstated. In simple terms, revenue is recorded when earned, and that has already taken place. Instead, for recording purposes, the accountant indicates that this increase in cash is caused by the decrease in the accounts receivable balance established in Transaction 4.

Payment Made on an Earlier Purchase

Question: Transaction 9—Inventory was bought in Transaction 1 for $2,000 and later sold in Transaction 4. Now, however, the company is ready to make payment of the amount owed for this merchandise. When cash is delivered to settle a previous purchase of inventory, what is the financial effect of the transaction?

Answer: As a result of the payment, cash is decreased by $2,000. The inventory was recorded previously when acquired. Therefore, this subsequent transaction does not replicate that effect. Instead, the liability established in number 1 is now removed from the books. The company is not buying the inventory again but simply paying off the debt established for these goods when they were purchased.

Payment of Rent in Advance

Question: Transaction 10—The company wants to rent a building to use for the next four months and pays the property’s owner $4,000 to cover this cost. When payment is made for rent (or a similar cost) with a future economic benefit, what recording is appropriate in financial accounting?

Answer: In acquiring the use of this property, the company’s cash decreases by $4,000. The money was paid to utilize the building for four months in the future. The anticipated economic benefit is an asset, and that information should be reported to decision makers by establishing a prepaid rent balance. Money has been paid to use the property at a designated time in the future to help generate revenues.

Double-Entry Bookkeeping

Question: Transaction analysis determines the changes that occur in accounts whenever various events take place. Financial statements eventually provide a formal structure to communicate the resulting balances to an array of interested parties.

• Revenues, expenses, gains, and losses are presented on an income statement where they are combined to arrive at reported net income for the period.
• Total income earned and dividends distributed by the company over its entire life are netted to compute the retained earnings balance to be reported.
• Assets, liabilities, capital stock, and retained earnings are all displayed on a balance sheet.
• Changes in cash are separated into operating activities, investing activities, and financing activities and disclosed on a statement of cash flows.
• Notes offer pages of additional explanatory information.

The amount of financial data that is readily available to any decision maker is impressive.

Accountants for a business of any significant size face a daunting challenge in creating financial statements. They must gather, measure, and report the impact of the many varied events that occur virtually every day. As an example, for 2010, Xerox Corporation disclosed revenues of over $21.6 billion and operating expenses and other costs of $20.8 billion. At the end of 2010, the Kellogg Company reported holding $1.1 billion in inventory—which is a lot of cereal—and indicated that its operating activities that year generated a net cash inflow of approximately $1 billion. How can any organization possibly amass and maintain such an enormous volume of data so that financial statements can be produced with no material misstatements?

Answer: Over five hundred years ago, Venetian merchants in Italy developed a system that continues to serve in the twenty-first century as the basis for accumulating financial data throughout much of the world. Today, when every aspect of modern society seems to be in a constant state of flux, a process that has remained in use for over five centuries is almost impossible to comprehend. However, the double-entry bookkeepingA mechanical process created over five hundred years ago and documented by Fra Luca Bartolomeo de Pacioli that facilitates the gathering and reporting of financial information. procedures that were first documented in 1494 by Fra Luca Bartolomeo de Pacioli (a friend of Leonardo da Vinci) remain virtually unchanged by time. Organizations, both small and large, use the fundamentals of double-entry bookkeeping to gather the monetary information needed to produce financial statements that are fairly presented according to the rules of U.S. GAAP or IFRS.

Analyze, Record, Adjust, and Report

Question: This assertion sounds like science fiction. It hardly seems believable that Xerox keeps up with over $21.6 billion in revenue (approximately $59 million per day) using the same methods that Venetian merchants applied to their transactions during the Renaissance. How can a five-hundred-year-old bookkeeping system possibly be usable in today’s modern world?

Answer: State-of-the-art computers and other electronic devices are designed to refine and accelerate the financial accounting process, but the same basic organizing procedures have been utilized now for hundreds of years. In simplest terms, accounting systems are all created to follow four sequential steps:

• Analyze
• Record
• Adjust
• Report

The first two of these steps are studied in this chapter. As explained previously, financial accounting starts by analyzing each transaction—every event that has a monetary impact on the organization—to ascertain the changes created in accounts such as rent expense, cash, inventory, and dividends paid. Fortunately, a vast majority of any company’s transactions are repetitive so that many of the effects can be easily anticipated. A sale on credit always increases both accounts receivable and revenue. Regardless of the time or place, a cash purchase of a piece of equipment increases the balance reported for equipment while decreasing cash. Computer systems can be programmed to record the impact of these events automatically allowing the accountant to focus on analyzing more complex transactions.

Debits, Credits, and T-Accounts

Question: The second step in the financial accounting process is “record.” At the beginning of this chapter, a number of transactions were presented and their impact on individual accounts determined. Following this analysis, some method must be devised to capture the information in an orderly fashion. Officials could just list the effect of each transaction on a sheet of paper:

“Increase inventory $2,000 and increase accounts payable $2,000.”

“Increase salary expense $300 and decrease cash $300.”

“Increase cash $9,000 and increase note payable $9,000.”

However, this process is slow and poorly organized. A more efficient process is required for companies like Xerox and Kellogg. After all monetary changes are identified, how are these effects accumulated?

Answer: An essential step in understanding double-entry bookkeeping is to realize that financial information is accumulated by accountsDetailed records of the transactions and current balances of individual assets, liabilities, stockholders’ equity, revenues and expenses.. As mentioned previously, every balance to be reported in a set of financial statements is maintained in a separate account. Thus, for assets, an individual account is established to monitor cash, accounts receivable, inventory, and so on. To keep track of expenses, a number of additional accounts are needed, such as cost of goods sold, rent expense, salary expense, and repair expense. The same is true for revenues, liabilities, and other categories. A small organization might utilize only a few dozen accounts in its entire record-keeping system. A large business probably has thousands.

Based on the original Venetian model, the balance for each account is monitored in a form known as a T-accountMaintains the monetary balance for each of the accounts reported by an organization with a left (debit) side and a right (credit) side used to show increases and decreases. as displayed in Figure 4.2 “Examples of Common T-Accounts”. This structure provides room for recording on both the left side (known as the debitLeft side of a T-account; it indicates increases in assets, expenses, and dividends paid as well as decreases in liabilities, capital stock, and revenue and gains. side) and the right side (the creditRight side of a T-account; it indicates increases in liabilities, capital stock, retained earnings, and revenue and gains as well as decreases in assets, expenses, and dividends paid. side).

Figure 4.2 Examples of Common T-Accounts

One side of every T-account records increases; the other side records decreases. For over five hundred years, the following rules have applied.

In some accounts, debits indicate an increase and credits indicate a decrease. They are grouped together because they all refer to costs.

Increase Shown with a Debit:

• Expenses and losses
• Assets
• Dividends paidOne method to keep track of these accounts initially is to remember them as the “DEAD” accounts: debits increase, expenses and losses, assets, and dividends paid. Quickly, though, through practice, such mnemonic devices will not be needed.

In other accounts, credits indicate an increase and debits indicate a decrease. They are grouped together because they all reflect sources of funding.

Increase Shown with a Credit:

• Liabilities
• Capital stock
• Revenues and gains
• Retained earningsChanges in the balance reported for retained earnings normally do not come as a direct result of a transaction. As discussed previously, this account reflects all the net income earned to date reduced by all dividend payments. Income is made up of revenues, expenses, gains, and losses. Accounting recognition of revenues and gains (which increase with credits) lead to a larger retained earnings balance. Expenses, losses, and dividends paid (which all increase with debits) reduce retained earnings. Consequently, credits cause an increase in retained earnings whereas debits produce a decrease.

The debit and credit rules for these seven general types of accounts provide a short-hand method for recording the financial impact that a transaction has on any account. They were constructed in this manner so that the following would be true:

At first view, the debit and credit rules might seem completely arbitrary. However, they are structured to mirror the cause-and-effect relationship found in every transaction. This is the basis of what the Venetian merchants came to understand so long ago: every effect must have a cause.

• Assume an asset (such as cash) increases. As shown here, that change is recorded on the debit side of the T-account for that asset. What could cause an asset to become larger? A reason must exist. A liability—possibly a bank loan—could have been incurred (recorded as a credit); capital stock could have been issued to an owner (a credit); revenue could have been earned from a sale (a credit). The list of possible reasons is relatively short. In each case, the debit (increase) to the asset is caused by an equal and offsetting credit.
• Assume an asset (such as cash) decreases. This change is recorded on the credit side of the asset’s T-account. What might cause this reduction? An expense could have been paid (recorded as a debit); a dividend could have been distributed to shareholders (a debit); a liability could have been extinguished (a debit); another asset could have been acquired (a debit). Once again, the cause-and-effect relationship is reflected; the debits equal the credits. Each effect is set equal and opposite to its cause.

There are only seven types of accounts. Therefore, a mastery of debit and credit rules can be achieved with a moderate amount of practice. Because of the fundamental role that debits and credits play within every accounting system, this knowledge is well worth the effort required to obtain it.

The Purpose of a Journal Entry

Question: In an accounting system, the impact of each transaction is analyzed and must then be recorded. Debits and credits are used for this purpose. How does the actual recording of a transaction take place?

Answer: The effects produced on various accounts by a transaction should be entered into an accounting system as quickly as possible so that information is not lost and mistakes have less time to occur. After each event is analyzed, the financial changes caused by a transaction are initially recorded as a journal entryThe physical form used in double-entry bookkeeping to record the financial changes caused by a transaction; each must have at least one debit and one credit and the total debit(s) must always equal the total credit(s)..In larger organizations, similar transactions are often grouped, summed, and recorded together for efficiency. For example, all cash sales at one store might be totaled automatically and recorded at one time at the end of each day. To help focus on the mechanics of the accounting process, the journal entries in this textbook will be prepared for transactions individually. A list of a company’s journal entries is maintained in a journalThe physical location of all journal entries; it is the financial diary of an organization capturing the impact of transactions as they took place; it is also referred to as the general journal. (also referred to as a general journalThe physical location of all journal entries; it is the financial diary of an organization capturing the impact of transactions as they took place; it is also referred to as the journal.), which is one of the most important components within any accounting system. The journal is a financial diary for a company. It provides a history of the impact of all financial events, recorded as they took place.

A journal entry is no more than an indication of the accounts and balances that were changed by a single transaction.

Practicing with Debits and Credits

Question: Debit and credit rules are best learned through practice. In order to master the use of debits and credits for recording purposes, where should the needed work begin?

Answer: When faced with debits and credits, everyone has to practice at first. That is normal and to be expected. These rules can be learned quickly but only by investing a bit of effort. Earlier in this chapter, a number of common transactions were presented (Figure 4.1 “Transactions Frequently Encountered by a Business”) and then analyzed to demonstrate their impact on account balances. Assume now that these same transactions are to be recorded as journal entries.

To provide more information for this illustration, the reporting company will be a small farm supply store known as the Lawndale Company that is located in a rural area. For convenience, assume that the business incurs each of these transactions during the final two days of Year Four, just prior to preparing financial statements.

Assume further that this company already has the various T-account balances as of December 29, Year Four, presented in Figure 4.3 “Balances From T-accounts in Ledger” before recording the impact of this last group of transactions. A company keeps its T-accounts together in a ledger (or general ledger). This listing of the account balances found in the ledger is known as a trial balanceList of account balances at a specific point in time for each of the T-accounts maintained in a company’s ledger; eventually, financial statements are created using these balances.. Note that the total of all the debit and credit balances do agree ($360,700) and that every account shows a positive balance. In other words, the current figure being reported is either a debit or credit based on what reflects an increase in that particular type of account. Few T-accounts contain negative balances.

Figure 4.3 Balances From T-accounts in Ledger

Journal Entry for Acquisition of Inventory on Credit

Question: After the balances in Figure 4.3 “Balances From T-accounts in Ledger” were determined, several additional transactions took place during the last two days of Year Four. The first transaction analyzed at the start of this chapter (Figure 4.1 “Transactions Frequently Encountered by a Business”) was the purchase of inventory on credit for $2,000. This acquisition increases the recorded amount of inventory while also raising one of the company’s liabilities (accounts payable). How is the acquisition of inventory on credit recorded in the form of a journal entry?

Answer: Following the transactional analysis, a journal entry is prepared to record the impact that the event has on the Lawndale Company. Inventory is an asset. An asset always uses a debit to note an increase. Accounts payable is a liability so that a credit indicates that an increase has occurred. Thus, the journal entry shown in Figure 4.4 “Journal Entry 1: Inventory Acquired on Credit” is appropriate.The parenthetical information is included here only for clarification purposes and does not appear in a true journal entry.

Figure 4.4 Journal Entry 1: Inventory Acquired on Credit

Notice that the word “inventory” is physically on the left of the journal entry and the words “accounts payable” are indented to the right. This positioning clearly shows which account is debited and which is credited. In the same way, the $2,000 numerical amount added to the inventory total appears on the left (debit) side whereas the $2,000 change in accounts payable is clearly on the right (credit) side.

Preparing journal entries is a mechanical process but one that is fundamental to the gathering of information for financial reporting purposes. Any person familiar with accounting could easily “read” the previous entry: Based on the debit and credit, both inventory and accounts payable have gone up so a purchase of merchandise for $2,000 on credit is indicated. Interestingly, with translation of the words, a Venetian merchant from the later part of the fifteenth century would be capable of understanding the information captured by this journal entry even if prepared by a modern company as large as Xerox or Kellogg.

Recording Payment of an Expense

Question: In Transaction 2, the Lawndale Company pays its employees salary of $300 for work performed during the past week. If no entry has been recorded previously for this amount, what journal entry is appropriate when a salary payment is made?

Answer: Because the information provided indicates that no entry has yet been made, neither the $300 salary expense nor the related salary payable already exists in the accounting records. Apparently, the $60,000 salary expense appearing in the trial balance reflects earlier payments made during the period to company employees.

Payment is made here for past work so this cost represents an expense rather than an asset. Thus, the balance recorded as salary expense goes up while cash decreases. As shown in Figure 4.5 “Journal Entry 2: Salary Paid to Employees”, increasing an expense is always shown by means of a debit. Decreasing an asset is reflected through a credit.

Figure 4.5 Journal Entry 2: Salary Paid to Employees

In practice, the date of each transaction could also be included here. For illustration purposes, this extra information is not necessary.

Journal Entry When Money Is Borrowed

Question: According to Transaction 3, $9,000 is borrowed from a bank when officials sign a note payable that will have to be repaid in several years. What journal entry is prepared by a company to reflect the inflow of cash received from a loan?

Answer: As always, recording begins with an analysis of the transaction. Cash—an asset—increases $9,000, which is shown as a debit. The notes payable balance also goes up by the same amount. As a liability, this increase is recorded through a credit. By using debits and credits in this way, a record of the financial effects of this transaction are entered into the accounting records.

Figure 4.6 Journal Entry 3: Money Borrowed from Bank

Recording Sale of Inventory on Credit

Question: In Transaction 1, inventory was bought for $2,000. That journal entry is recorded earlier. Now, in Transaction 4, these goods are sold for $5,000 to a customer with payment to be made at a later date. How is the sale of merchandise on credit recorded in journal entry form?

Answer: As discussed previously, two events happen when inventory is sold. First, the sale is made and, second, the customer takes possession of the merchandise from the company. Assuming again that a perpetual inventory system is in use, both the sale and the related expense are recorded immediately.

In the initial part of the transaction, the accounts receivable balance goes up $5,000 because the money from the customer will not be collected until a future point in time. The increase in this asset is shown by means of a debit. The new receivable resulted from a sale. Thus, revenue is also recorded (through a credit) to indicate the cause of that effect.

Figure 4.7 Journal Entry 4A: Sale of Inventory Made on Account

At the same time, inventory costing $2,000 is surrendered by the company. The reduction of any asset is recorded by means of a credit. The expense account that represents the outflow of inventory has been identified previously as “cost of goods sold.” Like any expense, it is entered into the accounting system through a debit.

Figure 4.8 Journal Entry 4B: Merchandise Acquired by Customers

The Role of Accrual Accounting

Question: In the previous transaction, the Lawndale Company made a sale but no cash was to be collected until some later date. Why is revenue reported at the time of sale rather than when cash is eventually collected? Accounting is conservative. Delaying recognition of sales revenue (and the resulting increase in net income) until the $5,000 is physically received seems logical. Why is the revenue recognized here before the cash is collected?

Answer: This question reflects a common misconception about the information conveyed through financial statements. As shown in Journal Entry 4A, the reporting of revenue is not tied directly to the receipt of cash. One of the most important components of U.S. GAAP is accrual accountingA method of accounting used by U.S. GAAP to standardize the timing of the recognition of revenues and expenses; it is made up of the revenue realization principle and the matching principle.. It serves as the basis for timing the recognition of revenues and expenses. Because of the direct impact on net income, such issues are among the most complicated and controversial in accounting. The accountant must constantly monitor events as they occur to determine the appropriate point in time for reporting each revenue and expense. Accrual accounting provides standard guidance for that process.

Accrual accounting is really made up of two distinct elements. The revenue realization principleThe component of accrual accounting that guides the timing of revenue recognition; it states that revenue is properly recognized when the earning process needed to generate the revenue is substantially complete and the amount to be received can be reasonably estimated. provides authoritative direction as to the proper timing for the recognition of revenue. The matching principleThe component of accrual accounting that guides the timing of expense recognition; it states that expense is properly recognized in the same time period as the revenue that it helped generate. establishes similar guidelines for expenses. These two principles have been utilized for decades in the application of U.S. GAAP. Their importance within financial accounting can hardly be overstated.

Revenue realization principle. Revenue is properly recognized at the point that (1) the earning process needed to generate the revenue is substantially complete and (2) the amount eventually to be received can be reasonably estimated. As the study of financial accounting progresses into more complex situations, both of these criteria will require careful analysis and understanding.

Matching principle. Expenses are recognized in the same time period as the revenue they help to create. Thus, if specific revenue is to be recognized in the year 2019, all associated costs should be reported as expenses in that same year. Expenses are matched with revenues. However, when a cost cannot be tied directly to identifiable revenue, matching is not possible. In those cases, the expense is recognized in the most logical time period, in some systematic fashion, or as incurred—depending on the situation.

Revenue is reported in Journal Entry 4A. Assuming that the Lawndale Company has substantially completed the work required of this sale and $5,000 is a reasonable estimate of the amount that will be collected, recognition at the time of sale is appropriate. Because the revenue is reported at that moment, the related expense (cost of goods sold) should also be recorded as can be seen in Journal Entry 4B.

Accrual accounting provides an excellent example of how U.S. GAAP guides the reporting process in order to produce fairly presented financial statements that can be understood by all possible decision makers.

Payment of a Previously Recognized Expense

Question: In Transaction 5, the Lawndale Company pays $700 for insurance coverage received over the past few months. Here, though, the amount has already been recognized. Both the insurance expense and an insurance payable were recorded as incurred. That information was provided in Figure 4.1 “Transactions Frequently Encountered by a Business”, and both amounts can be seen on the trial balance in Figure 4.3 “Balances From T-accounts in Ledger”. Apparently, Lawndale’s accounting system was programmed to recognize this particular expense as it grew over time. When an expense has already been recorded, what journal entry is appropriate at the time payment is made?

Answer: Because of the previous recognition, the expense should not now be recorded a second time. Instead, this payment eliminates the liability that was established by the accounting system. Cash—an asset—is decreased, which is shown in accounting by means of a credit. At the same time, the previously recorded payable is removed. Any reduction of a liability is communicated by a debit. To reiterate, no expense is included in this entry because that amount has already been recognized as incurred.

Figure 4.9 Journal Entry 5: Payment of Liability for Insurance Coverage

Note that Journal Entries 2 and 5 differ although the events are similar. As discussed previously, specific recording techniques are influenced by the manner in which the accounting system has handled earlier events. In Journal Entry 2, neither the expense nor the payable had yet been recorded. Thus, the expense was recognized at the time of payment. Conversely, in Journal Entry 5, both the expense and payable had already been entered into the records as the amount gradually grew over time. Hence, when paid, the liability is settled, but no further expense is recognized. The proper amount is already present in the insurance expense T-account.

Acquisition of an Asset

Question: In Transaction 6, a new truck is acquired by the Lawndale Company for $40,000. Cash of $10,000 is paid at the time of purchase but a note payable—due in several years—is signed for the remaining $30,000. This transaction impacts three accounts rather than just two. How is a journal entry constructed when more than two accounts are affected?

Answer: As has been discussed, every transaction changes at least two accounts because of the cause-and-effect relationship underlying all financial events. However, beyond that limit, any number of accounts can be impacted. Complex transactions often touch numerous balances. Here, the truck account (an asset) is increased and must be debited. Part of the acquisition was funded by paying cash (an asset) with that decrease recorded as a credit. The remainder of the cost was covered by signing a note payable (a liability). Any increase in a liability is recorded by means of a credit. Note that the debits do equal the credits even when more than two accounts are affected by a transaction.

Figure 4.10 Journal Entry 6: Truck Acquired for Cash and by Signing a Note

Issuance of Capital Stock

Question: In Transaction 7, the Lawndale Company needs additional financing so officials go to current or potential shareholders and convince them to contribute cash of $19,000 in exchange for new shares of the company’s capital stock. These individuals invest their money in order to join the ownership or increase the number of shares they already hold. What journal entry does a business record when capital stock is issued?

Answer: The asset cash is increased in this transaction, a change that is always shown as a debit. Capital stock also goes up because new shares are issued to company owners. As indicated in the debit and credit rules, the capital stock account increases by means of a credit.

Figure 4.11 Journal Entry 7: Capital Stock Issued for Cash

Collection Made on Account Receivable

Question: In Journal Entry 4A, a sale was made on credit. An account receivable was established at that time for $5,000. Assume that the customer now pays this amount to the Lawndale Company. How does the collection of an amount from an earlier sales transaction affect the account balances?

Answer: When a customer makes payment on a previous sale, the cash balance increases while accounts receivable decrease. Both are assets; one balance goes up (by a debit) while the other is reduced (by a credit).

Figure 4.12 Journal Entry 8: Money Collected on Account

Note that cash is collected here, but no additional revenue is recorded. Based on the requirements of accrual accounting, revenue of $5,000 was recognized previously in Journal Entry 4A. Apparently, the revenue realization principle was met at that time, the earning process was substantially complete, and a reasonable estimation could be made of the amount to be received. Recognizing the revenue again at the current date would incorrectly inflate reported net income. Instead, the previously created receivable balance is removed.

Paying for a Previous Purchase

Question: In Journal Entry 1, inventory was purchased on credit for $2,000. Assume, now, in Transaction 9, that Lawndale makes payment of the entire amount that is due. How is a cash outflow to pay for inventory previously acquired shown in a company’s journal?

Answer: Inventory was bought at an earlier time, and payment is now being made. The inventory was properly recorded when acquired and should not be entered again. The merchandise was only obtained that one time. Here, cash is reduced (a credit). The liability set up in Journal Entry 1 (accounts payable) is removed by means of a debit.

Figure 4.13 Journal Entry 9: Money Paid for Previous Purchase

Prepayment of an Expense

Question: Company officials like the building that is being used for operations and decide to rent it for four additional months at a rate of $1,000 per month. An immediate payment of $4,000 is made. This cost provides a future economic benefit rather than a past value. Recognition of an expense is not yet appropriate. What recording is appropriate when rent or other costs such as insurance or advertising are paid in advance?

Answer: Cash is decreased by the payment made here to rent this building. As an asset, a reduction in cash is reported by means of a credit. However, this rent provides a future value for Lawndale Company. The cost is not for past usage of the building but rather for the upcoming months. Therefore, the amount paid creates an asset. The probable economic benefit is the ability to make use of this facility over the next four months to generate new revenue. When the $4,000 is paid, an asset—normally called prepaid rent—is recorded through a debit.

Figure 4.14 Journal Entry 10: Money Paid for Future Rent

Note that Lawndale does not record the building itself because the company does not gain ownership or control (beyond these four months). The payment only provides the right to make use of the building for the specified period in the future so that a prepaid rent balance is appropriate.

Acquisition of Land

Question: Before this illustration of typical journal entries is completed, four additional transactions will be examined. In total, these fourteen provide an excellent cross-section of basic events encountered by most businesses and the journal entries created to capture that information. An understanding of the recording of these transactions is of paramount importance in mastering the mechanical rules for debits and credits.

Officials of the Lawndale Company decide to purchase a small tract of land by paying $8,000 in cash. Perhaps they think the space might be used sometime in the future as a parking lot. What recording is made to reflect the cash purchase of a plot of land?

Answer: The transaction here is straightforward. As an asset, land increases with a debit. The company’s cash balance goes down because of the acquisition. That drop is recorded using a credit. As stated earlier in this section, Venetian merchants would probably have made the same recording five hundred years ago (although not in U.S. dollars).

Figure 4.15 Journal Entry 11: Land Acquired for Cash

Sale of an Asset Other Than Inventory

Question: Now, assume that—for demonstration purposes—this same piece of land is sold almost immediately to an outside party for cash of $11,000. A sale occurs but the land is not inventory. It was not bought specifically to be resold within the normal course of business. As a farm supply store, selling land is not the primary operation of the Lawndale Company. Should revenue be recorded along with cost of goods sold when land rather than inventory is sold? These two accounts are used in journalizing the sale of inventory. Does the same reporting apply to the sale of other assets such as land or equipment?

Answer: Because the sale of land is not viewed as a central portion of this company’s operations, neither revenue nor cost of goods sold is reported as in the sale of inventory. An $11,000 increase in cash is recorded along with the removal of the $8,000 cost of the land that was conveyed to the new owner. However, to alert decision makers that a tangential or incidental event has taken place, a gain (if the sales price is more than the cost of the land) or a loss (if sales price is less than cost) is recognized for the difference. The effect on net income is the same (a net increase of $3,000), but the method of reporting has changed.

The resulting gain or loss is then separated from revenues and expenses on the income statement to more clearly communicate information as to the nature of the transaction. The decision maker can see the operating income earned by the reporting company from the normal sale of goods and services distinct from any other gains and losses. For example, if an investor or creditor is looking at the financial statements produced by an Italian restaurant, the amount of income from selling pizzas, spaghetti, and the like is important information apart from any gains and losses that were not part of typical operations. Consequently, neither revenue nor cost of goods sold is found in the following entry as was demonstrated in Journal Entries 4A and 4B.

Figure 4.16 Journal Entry 12: Land Sold for Cash in Excess of Cost

Receiving Cash before the Earning Process Is Complete

Question: Accrual accounting, as specified in the revenue realization principle, mandates that revenues should not be recognized until the earning process is substantially complete. Assume a customer gives the Lawndale Company $3,000 in cash for some type of service to be performed at a future date. The work has not yet begun. Thus, Lawndale cannot report revenue of $3,000. How is a cash inflow recorded if received for work before the earning process is substantially complete?

Answer: Although cash is received, accrual accounting dictates that revenue cannot be recognized until the earning process is substantially complete. Here, the earning process will not take place for some time in the future. As an asset, the cash account is increased (debit) but no revenue can yet be recorded. Instead, an unearned revenue account is established for the $3,000 credit. This balance is reported by the Lawndale Company as a liability. Because the money has been accepted, the company is obliged to provide the service or return the $3,000 to the customer. Recording this liability mirrors that responsibility.

Figure 4.17 Journal Entry 13: Money Received for Work to Be Done Later

Distribution of a Dividend

Question: Here is one final transaction to provide a full range of basic examples at this preliminary stage of coverage. Many additional transactions and their journal entries will be introduced throughout this textbook, but these fourteen form a strong core of the typical events encountered by most businesses.

Assume that the Lawndale Company has been profitable. As a result, at the end of the year, the board of directors votes to distribute a cash dividend to all owners, a reward that totals $600. Payment is made immediately. What recording is appropriate when a dividend is distributed to the owners of a corporation?

Answer: Cash is reduced by this payment to the company’s owners. As an asset, a credit is appropriate. The cause of the decrease in cash was a dividend. Hence, a “dividends paid” account is established to measure this particular outflow of net assets. According to the debit and credit rules, an increase in this account is shown through a debit. Thus, the recording of this last illustration is as follows.

Figure 4.18 Journal Entry 14: Dividend Distributed to Owners

To help visualize the components of an accounting system, all of the journal entries presented here have been gathered into an actual journal in Figure 4.19 “Lawndale Company Journal—Final Days of Year Four” as the accountant for the Lawndale Company might have kept. Normally, a date for each entry is included for reference purposes, but that has been omitted here.

Figure 4.19 Lawndale Company Journal—Final Days of Year Four

Current T-Account Balances

Question: With adequate practice, obtaining an understanding of the rules for debits and credits is a reasonable goal. However, these journal entries do not provide the current balance of any account. They record the effect of each transaction but not the updated account totals, figures that could change many times every day. How does an accountant keep track of the current balance of cash, inventory, rent expense, or the myriad other accounts that appear on a set of financial statements?

Answer: In an accounting system, the recording process is composed of two distinct steps.

1. After analyzing the financial impact of a transaction, a journal entry is created to reflect the monetary impact on relevant accounts.
2. Then, each individual debit and credit is added to the specific T-account being altered, a process known as “posting.” A debit to cash in a journal entry is listed as a debit in the cash T-account. A credit made to notes payable is recorded as a credit within the corresponding T-account. After all entries are posted, the current balance for any account can be determined by adding the debit and the credit sides of the T-account and netting the two.

Historically, posting the individual changes shown in each journal entry to the specific T-accounts was a tedious and slow process performed manually. Today, automated systems are designed so that the impact of each entry is simultaneously recorded in the proper T-accounts found in the ledger.

For illustration purposes, all of the journal entries recorded earlier have been posted into the ledger T-accounts shown in Figure 4.19 “Lawndale Company Journal—Final Days of Year Four”. Each account includes the previous balance (PB) found in the trial balance in Figure 4.3 “Balances From T-accounts in Ledger”. The new debits and credits are then posted for each of the fourteen sample transactions. For cross-referencing purposes, the number of the corresponding journal entry is included. The debit and credit sides of each account are summed and netted to determine the current balance (CB). For example, the cash T-account has $67,000 as the total of all debits and $25,600 for all credits, which net to a current balance of $41,400.

After all of the additional journal entries have been posted into the ledger, an updated trial balance can be drawn from the individual T-account balances. No change is created by this process, but, as can be seen in Figure 4.21 “Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four”, the accounts and their current balances are much easier to see. Simply the clarity of the information can help accountants spot accounts that may contain errors because of unusual or unexpected totals.

Figure 4.20 Lawndale Company Ledger—December 31, Year Four

Figure 4.21 Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four