Chapter 3

The
Accounting
Cycle:
Capturing
Economic
Events

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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The Accounting Cycle
Accounting records are used to:
◦ Prepare financial statements.
◦ Complete income tax returns.
◦ Create other reports.

The accounting cycle is the sequence of

accounting procedures used to record, classify,
and summarize accounting information in
financial reports at regular intervals.

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Steps of the Accounting Cycle
1. Journalize (record) transactions.
2. Post each journal entry to ledger accounts.
3. Prepare a trial balance.
4. Make end-of-period adjusting entries.
5. Prepare adjusted trial balance.
6. Prepare financial statements.
7. Journalize and post closing entries.
8. Prepare after-closing trial balance.

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The Ledger
Account: the record used to keep track of the
increases and decreases in financial statement
items; may also be called a “ledger account.”

Ledger: the accounting record which includes

the entire group of individual accounts.

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The Use of Accounts
Each account has three elements:
1. A title
2. A left side, which is called the debit side
3. A right side, which is called the credit side

KEY POINT
Whether an account is increased or decreased by a debit or credit
entry will depend on the account type (i.e. asset, liability, etc.). We
will learn more about this throughout the chapter.

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Using T Accounts

Increases are recorded on

one side of the T account, Title of Account
and decreases are recorded
Left Right
on the other side. or or
Debit Credit
Side Side

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 Debit and Credit Entries
Cash
Receipts
are on
the debit
1/20 80,000 1/21 52,000 Payments
side. 1/26 600 1/22 6,000 are on the
credit side.
1/31 2,200 1/27 6,800
1/31 200
1/31 1,200
1/31 16,600 The
Thebalance
balanceisisthe
the
difference
differencebetween
betweenthethe
debit
debitandandcredit
creditentries
entries
in
inthe
theaccount.
account.

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Rules of Debit and Credit Entries

Debits and credits affect accounts as follows:

A = L + OE
ASSETS LIABILITIES OWNERS’ EQUITY
Debit for Credit for Debit Credit Debit Credit
Increase Decrease for for for for
Decrease Increase Decrease Increase

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Debit Balances in Asset Accounts
Asset accounts are increased by debit entries
and decreased by credit entries.
Asset accounts have a normal debit balance.
The fact that assets are located on the left side of
the balance sheet is a convenient means of
remembering the rule that an increase in an asset
is recorded on the left (debit) side of the account
and an asset account normally has a debit (left-
hand) balance.

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Credit Balances in Liabilities and Equity
 Liability accounts and owners’ equity accounts are
increased by credits and decreased by debits.
 The relationship between entries in these accounts and
their position on the balance sheet may be summed up
as follows:
1. Liabilities and owners’ equity belong on the right side of
the balance sheet.
2. An increase in a liability or an owners’ equity account is
recorded on the right (credit) side of the account.
3. Liability and owners’ equity accounts normally have
credit (right-hand) balances.

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Debit and Credit Rule Summary

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 Double-Entry AccountingThe
Equality of Debits and Credits

A = L + OE
=
Debit Credit
balances balances

In
In the
the double-entry
double-entry accounting
accounting system,
system,
every
every transaction
transaction is
is recorded
recorded by
by equal
equal dollar
dollar
amounts
amounts of
of debits
debits and
and credits.
credits.
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The Journal
In an actual accounting system, the information
about each business transaction is initially
recorded in an accounting record called the
journal.
The journal is a chronological (day-by-day)
record of business transactions.
This information is later transferred to the
appropriate accounts in the general ledger.

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The Journal (cont.)
At convenient intervals, the debit and credit
amounts recorded in the journal are transferred
(posted) to the accounts in the ledger.
The updated ledger accounts, in turn, serve as
the basis for preparing the company’s financial
statements.

3-14
 Example: Transaction 1
On January 20, 2018, the McBryan family invested
$80,000 in exchange for capital stock. Thus, the asset Cash
increased by $80,000, and the owners’ equity account
Capital Stock increased by the same amount.

Applying the debit and credit rules discussed

previously, we know that increases in assets are
recorded by debits, whereas increases in owners’ equity
are recorded by credits. As such, this event requires a
debit to Cash and a credit to Capital Stock in the
amount of $80,000.

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 Example: Transaction 1 (cont.)
GENERAL JOURNAL
Date Account Titles and Explanation Debit Credit
2018
Jan. 20 Cash 80,000
Capital Stock 80,000
Owners invest cash in the business.

Note the basic characteristics of this general journal entry.

1. The name of the account debited (Cash) is written first, and the
dollar amount to be debited appears in the left-hand money
column.
2. The name of the account credited (Capital Stock) appears
below the account debited and is indented to the right. The
dollar amount appears in the right-hand money column.
3. A brief description of the transaction appears immediately
below the journal entry.
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Posting Journal Entries to the Ledger
Posting simply means updating the ledger
accounts for the effects of the transactions
recorded in the journal.
Posting involves copying into the ledger
accounts information that already has been
recorded in the journal.
KEY POINT
In manual accounting systems, this can be a tedious and time-
consuming process, but in computer-based systems, it is done
instantly and automatically. In addition, computerized posting greatly
reduces the risk of errors.

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 Posting the Journal Entry to Cash

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R De bit Cre di
2018
Jan 20 Cas h 80,000
Capital S to c k 80,0
Owne rs inve s tGe
c asne
h inral
the Le
busdg
ine sesr.

Cas h
Date De bit Cre dit Balanc e
2018
Jan 20 80,000 80,000
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 Posting the Journal Entry to Capital
Stock

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R De bit Cre di
2018
Jan 20 Cas h 80,000
Capital S to c k 80,0
Owne rs inve s t c as h in the bus ine s s .
Ge ne ral Le dg e r
Capital S to c k
Date De bit Cre dit Balanc e
2018
Jan 20 80,000 80,000
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Summary of January 20 Entry

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Summary of January 21 Entry
Representing Overnight, McBryan negotiated with both the City of
Santa Teresa and Metropolitan Transit Authority (MTA) to purchase
an abandoned bus garage. (The city owned the land, but the MTA
owned the building.) On January 21, Overnight Auto Service
purchased the land from the city for $52,000 cash.

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Summary of January 22 Entry
Overnight completed the acquisition of its business location by purchasing
the abandoned building from the MTA. The purchase price was $36,000;
Overnight made a $6,000 cash down payment and issued a 90-day, non-
interest-bearing note payable for the remaining $30,000.

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Summary of January 23 Entry
Overnight purchased tools and equipment on account from Snappy
Tools. The purchase price was $13,800, due in 60 days.

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Summary of January 24 Entry
Overnight found that it had purchased more tools than it needed. On
January 24, it sold the excess tools on account to Ace Towing at a
price of $1,800. The tools were sold at a price equal to their cost, so
there was no gain or loss on this transaction.

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Summary of January 26 Entry
Overnight received $600 in partial collection of the account
receivable from Ace Towing.

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Summary of January 27 Entry
Overnight made a $6,800 partial payment of its account payable to
Snappy Tools.

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Ledger Accounts after Posting

Ge ne ral Le dg e r
Cas h
Date De bit Cre dit Balanc e
2018
Jan 20 80,000 80,000
21 52,000 28,000

TTaccounts
accounts are
aresimplified
simplifiedversions
versionsof
of the
theledger
ledger
account
account that
that only
only show
show the
the debit
debitand
andcredit
credit columns.
columns.

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 What Is Net Income?
Net
Net income
income is
is not
not an asset it’s
an asset it’s an
an increase
increase
in
in owners’
owners’equity
equity from
from profits
profits of
of the
the
business.
business.

A = L + OE
Increase Decrease Increase

As income is earned, Net income

either an asset is always results in
increased or a liability is the increase of
decreased. Owners’ Equity.
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Retained Earnings

A = L + OE
Capital Retained
Stock Earnings

The balance in the Retained Earnings account

represents the total net income of the corporation
over the entire lifetime of the business, less all
amounts which have been distributed to the
stockholders as dividends.

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Overnight’s Income Statement
OVERNIGHT AUTO SERVICE
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2018
Revenue:
Repair service revenue $172,000
Rent revenue earned 3,000
Total revenue $175,000

Expenses:
Advertising $3,900

Salaries and wages 58,750

Supplies 7,500

Depreciation: building 1,650

Depreciation: tools and equipment 2,200

Utilities 19,400

Insurance 15,000

Interest 30 108,430

Income before income taxes $66,570

Income taxes 26,628
Net income $39,942

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Accounting Period Terminology
Accounting period—the period of time covered
by an income statement.
Time period principle—net income is
measured for relatively short accounting periods
of equal length to facilitate the interpretation of
financial events and the preparation of financial
statements.
Fiscal year—the 12-month accounting period
used by an entity.

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Revenue
Revenue is the price of goods sold and services
rendered during an accounting period.
◦ Causes owners’ equity to increase.
◦ Results in an increase in cash or accounts
receivable.
◦ Represents the gross increase in owners’
equity resulting from operation of the
business.

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Realization Principle
The realization principle indicates that revenue
should be recognized at the time goods are sold or
services are rendered.
◦ The business must have essentially completed
the earnings process.
◦ The sales value of the goods or services can be
measured objectively.

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Expenses
Expenses are the costs of the goods and services
used up in the process of earning revenue.
◦ Examples include the cost of salaries,
advertising, rent, utilities, and depreciation of
long-term assets.
◦ Necessary to attract and serve customers.
◦ Causes a decrease in owners’ equity.
◦ Results in either a decrease in assets or an
increase to liabilities (accounts payable).

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The Matching Principle
The matching principle refers to the concept of
offsetting expenses against revenue on a basis of
cause and effect.
◦ Expenses are incurred for the purpose of
producing revenue.
◦ In order to measure net income for a period,
revenue should be offset by all the expenses
incurred in producing that revenue.

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Debit and Credit Rules for Revenue
and Expenses
The debit and credit rules for recording revenue and expenses
in the ledger accounts are a natural extension of the rules for
recording changes in owners’ equity:
 Increases in owners’ equity are recorded by credits.
 Decreases in owners’ equity are recorded by debits.

This rule is now extended to cover revenue and expense

accounts.
 Revenue increases owners’ equity; therefore, revenue is
recorded by credits.
 Expenses decrease owners’ equity; therefore, expenses are
recorded by debits.

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Revenue and Expense T Accounts
Expenses EQUITIES Revenues
decrease Debit Credit increase
owners’ for for owners’
equity. Decrease Increase equity.

EXPENSES REVENUES
Debit Credit Debit Credit
for for for for
Increase Decrease Decrease Increase

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Dividends
A dividend is a distribution of assets (usually
cash) by a corporation to its stockholders.
◦ Reduces both assets and owners’ equity.
◦ Is not classified as an expense.
◦ Represents a distribution of profits to the
owners of the business.

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 Dividends (cont.)
Payments to Owners’
EQUITIES
owners investments
decrease Debit Credit increase
for for
owners’ Decrease Increase owners’
equity. equity.

DIVIDENDS CAPITAL STOCK

Debit Credit Debit Credit
for for for for
Increase Decrease Decrease Increase

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Income Statement Transactions
Illustrated
In the following slides, we will continue our
analysis of Overnight Auto Service by
examining their transactions related to:
◦ Revenue
◦ Expense
◦ Dividends

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Summary of January 31 Transaction
Recorded revenue of $2,200, all of which was received in cash.

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Summary of January 31 Entry 2
Paid employees’ wages earned in January, $1,200.

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Summary of January 31 Entry 3
Paid for utilities used in January, $200.

3-43
February 1 Transaction
Paid Daily Tribune $360 cash for newspaper advertising to be run
during February.

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February 2 Transaction
Purchased radio advertising from KRAM to be aired in February.
The cost was $470, payable within 30 days.

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February 4 Transaction
Purchased various shop supplies (such as grease, solvents, nuts, and
bolts) from CAPA Auto Parts; the cost was $1,400, due in 30 days.
These supplies are expected to meet Overnight’s needs for three or
four months.

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February 15 Transaction
Collected $4,980 cash for repairs made to vehicles of
Airport Shuttle Service.

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February 28 Transaction 1
Billed Harbor Cab Co. $5,400 for maintenance and repair services
Overnight provided in February. The agreement with Harbor Cab
calls for payment to be received by March 10.

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February 28 Transaction 2
Paid employees’ wages earned in February, $4,900.

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February 28 Transaction 3
Recorded $1,600 utility bill for February. The entire amount is due
March 15.

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February 28 Transaction 4
Overnight Auto Services declares and pays a dividend of 40 cents
per share to the owners of its 8,000 shares of capital stock—a total
of $3,200.

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Overnight’s Trial Balance

All balances are taken from the ledger accounts on Feb. 28 after
considering all of Overnight’s transactions for the month.
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 Uses and Limitations of the Trial
Balance
The trial balance provides proof that the ledger is in
balance. The agreement of the debit and credit totals of the
trial balance gives assurance that:
1. Equal debits and credits have been recorded for all
transactions.
2. The addition of the account balances in the trial
balance has been performed correctly.

KEY POINT
The preparation of a trial balance does not prove that transactions
have been correctly analyzed and recorded in the proper accounts. It
is still possible that an entry was posted to incorrect account(s) or that
an entry was omitted all together.

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Locating Errors on the Trial Balance
Suppose that the debit and credit totals of the trial
balance do not agree. This situation indicates that one
or more errors have been made. Typical of such errors
are:
1. Post of a debit as a credit or vice versa.
2. Mathematical mistakes in computing account
balances.
3. Clerical errors in copying account balances.
4. Listing a debit balance in the credit column or
vice versa.
5. Errors in addition of the trial balance.

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End of Chapter 3

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