Chapter Summary

The accounting cycle generally consists of eight specific steps: (1) journalizing (recording) transactions, (2) posting each journal entry to the appropriate ledger accounts, (3) preparing a trial balance, (4) making end-of-period adjustments, (5) preparing an adjusted trial balance, (6) preparing financial statements, (7) journalizing and posting closing entries, and (8) preparing an after-closing trial balance. Accounting records provide the information that is summarized in financial statements, income tax returns, and other accounting reports. In addition, these records are used by the company's management and employees for such purposes as:

• Establishing accountability for assets and transactions.
• Keeping track of routine business activities.
• Obtaining details about specific transactions.
• Evaluating the performance of units within the business.
• Maintaining a documentary record of the business activities. (Such a record is required by tax laws and is useful for many business purposes, including audits.)

A ledger account is a device for recording the increases or decreases in one financial statement item, such as a particular asset, a type of liability, or owner's equity. The ledger is an accounting record that includes all the ledger accounts - that is, a separate account for each item included in the company's financial statements.

Increases in assets are recorded by debits and decreases are recorded by credits. Increases in liabilities and in owner's equity are recorded by credits and decreases are recorded by debits. Notice that the debit and credit rules are related to an account's location in the balance sheet. If the account appears on the left-hand side of the balance sheet (asset accounts), increases in the account balance are recorded by left-side entries (debits). If the account appears on the right-hand side of the balance sheet (liability and owner's equity accounts), increases are recorded by right-side entries (credits).

The double-entry system of accounting takes its name from the fact that every business transaction is recorded by two types of entries: (1) debit entries to one or more accounts and (2) credit entries to one or more accounts. In recording any transaction, the total dollar amount of the debit entries must equal the total dollar amount of the credit entries.

The journal, or book of original entry, is the accounting record in which business transactions are initially recorded. The entry in the journal shows which ledger accounts have increased as a result of the transaction, and which have decreased. After the effects of the transaction have been recorded in the journal, the changes in the individual ledger accounts are then posted to the ledger.

Net income is an increase in owner's equity that results from the profitable operation of a business during an accounting period. Net income also may be defined as revenue minus expenses. Revenue is the price of goods sold and services rendered to customers during the period, and expenses are the costs of the goods and services used up in the process of earning revenue.

The realization principle indicates that revenue should be recorded in the accounting records when it is earned - that is, when goods are sold or services are rendered to customers. The matching principle indicates that expenses should be offset against revenue on the basis of cause and effect. Thus, an expense should be recorded in the period in which the related good or service is consumed in the process of earning revenue.

The debit and credit rules for recording revenue and expenses are based on the rules for recording changes in owner's equity. Earning revenue increases owner's equity; therefore, revenues are recorded with credit entries. Expenses reduce owner's equity and are recorded with debit entries.

In a trial balance, separate debit and credit columns are used to list the balances of the individual ledger accounts. The two columns are then totaled to prove the equality of the debit and credit balances. This process provides assurance that (1) the total of the debits posted to the ledger was equal to the total of the credits and (2) the balances of the individual ledger accounts were correctly computed. While a trial balance proves the equality of debit and credit entries in the ledger, it does not detect such errors as failure to record a business transaction, improper analysis of the accounts affected by the transaction, or the posting of debit or credit entries to the wrong accounts.

Accounting procedures involve the steps and processes necessary to prepare accounting information. A knowledge of the discipline enables one to use accounting information in evaluating performance, forecasting operations, and making complex business decisions.

In this chapter, we have illustrated the initial steps of the accounting cycle for a service-type business (accounting for merchandising activities will be discussed in Chapter 6). We have seen how businesses analyze and journalize transactions, post transactions to appropriate ledger accounts, and prepare trial balances. In Chapter 4, we will examine adjustments made for accrual and deferral of revenue and expenses. In Chapter 5, we complete the accounting cycle by illustrating the preparation of financial statements and the year-end closing process.