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Analyzing and Recording Transactions

Chapter Outline
3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial
Statements
3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing
Transactions
3.3 Define and Describe the Initial Steps in the Accounting Cycle

3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business
Transactions on Financial Statements
3.5 Use Journal Entries to Record Transactions and Post to T-Accounts

3.6 Prepare a Trial Balance

Why It Matters
Mark Summers wants to start his own dry-cleaning business upon finishing college. He has chosen to name his
business Supreme Cleaners. Before he embarks on this journey, Mark must establish what the new business will
require. He needs to determine if he wants to have anyone invest in his company. He also needs to consider any
loans that he might need to take out from his bank to fund the initial start-up. There are daily business activities that
Mark will need to keep track of, such as sales, purchasing equipment, paying bills, collecting money from
customers, and paying back investors, among other things. This process utilizes a standard accounting framework
so that the financial operations are comparable to other company’s financial operations.
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He knows it is important for him to keep thorough documentation of these business activities to give his investors and
creditors, and himself, a clear and accurate picture of operations. Without this, he may find it difficult to stay in
business. He will maintain an organized record of all of Supreme Cleaners’ financial activities from their inception,
using an accounting process meant to result in accurate financial statement preparation.

3.1 Describe Principles, Assumptions, and Concepts of

Accounting and Their Relationship to Financial Statements
If you want to start your own business, you need to maintain detailed and accurate records of business performance
in order for you, your investors, and your lenders, to make informed decisions about the future of your company.
Financial statements are created with this purpose in mind. A set of financial statements includes the income
statement, statement of owner’s equity, balance sheet, and statement of cash flows. These statements are
discussed in detail in Introduction to Financial Statements. This chapter explains the relationship between financial
statements and several steps in the accounting process. We go into much more detail in The Adjustment Process
and Completing the Accounting Cycle.

Accounting Principles, Assumptions, and Concepts

In Introduction to Financial Statements, you learned that the Financial Accounting Standards Board (FASB) is an
independent, nonprofit organization that sets the standards for financial accounting and reporting, including
generally accepted accounting principles (GAAP), for both public- and private-sector businesses in the United
States.
As you may also recall, GAAP are the concepts, standards, and rules that guide the preparation and presentation of
financial statements. If US accounting rules are followed, the accounting rules are called US GAAP. International
accounting rules are called International Financial Reporting Standards (IFRS). Publicly traded companies (those
that offer their shares for sale on exchanges in the United States) have the reporting of their financial operations
regulated by the Securities and Exchange Commission (SEC).
You also learned that the SEC is an independent federal agency that is charged with protecting the interests of
investors, regulating stock markets, and ensuring companies adhere to GAAP requirements. By having proper
accounting standards such as US GAAP or IFRS, information presented publicly is considered comparable and
reliable. As a result, financial statement users are more informed when making decisions. The SEC not only
enforces the accounting rules but also delegates the process of setting standards for US GAAP to the FASB.
Some companies that operate on a global scale may be able to report their financial statements using IFRS. The
SEC regulates the financial reporting of companies selling their shares in the United States, whether US GAAP or
IFRS are used. The basics of accounting discussed in this chapter are the same under either set of guidelines.

ETHICAL CONSIDERATIONS

Auditing of Publicly Traded Companies

When a publicly traded company in the United States issues its financial statements, the financial
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statements have been audited by a Public Company Accounting Oversight Board (PCAOB) approved auditor.
The PCAOB is the organization that sets the auditing standards, after approval by the SEC. It is important to
remember that auditing is not the same as accounting. The role of the Auditor is to examine and provide
assurance that financial statements are reasonably stated under the rules of appropriate accounting principles.
The auditor conducts the audit under a set of standards known as Generally Accepted Auditing Standards. The
accounting department of a company and its auditors are employees of two different companies. The auditors
of a company are required to be employed by a different company so that there is independence.

The nonprofit Center for Audit Quality explains auditor independence: “Auditors’ independence from company
management is essential for a successful audit because it enables them to approach the audit with the
necessary professional skepticism.”[1] The center goes on to identify a key practice to protect independence
by which an external auditor reports not to a company’s management, which could make it more difficult to
maintain independence, but to a company’s audit committee. The audit committee oversees the auditors’ work
and monitors disagreements between management and the auditor about financial reporting. Internal auditors
of a company are not the auditors that provide an opinion on the financial statements of a company. According
to the Center for Audit Quality, “By law, public companies’ annual financial statements are audited each year
by independent auditors—accountants who examine the data for conformity with U.S. Generally Accepted
Accounting Principles (GAAP).”[2] The opinion from the independent auditors regarding a publicly traded
company is filed for public inspection, along with the financial statements of the publicly traded company.

The Conceptual Framework

The FASB uses a conceptual framework, which is a set of concepts that guide financial reporting. These concepts
can help ensure information is comparable and reliable to stakeholders. Guidance may be given on how to report

transactions, measurement requirements, and application on financial statements, among other things.[3]

IFRS CONNECTION

GAAP, IFRS, and the Conceptual Framework

The procedural part of accounting—recording transactions right through to creating financial statements—is a
universal process. Businesses all around the world carry out this process as part of their normal operations. In
carrying out these steps, the timing and rate at which transactions are recorded and subsequently reported in
the financial statements are determined by the accepted accounting principles used by the company.
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As you learned in Role of Accounting in Society, US-based companies will apply US GAAP as created by the
FASB, and most international companies will apply IFRS as created by the International Accounting Standards
Board (IASB). As illustrated in this chapter, the starting point for either FASB or IASB in creating accounting
standards, or principles, is the conceptual framework. Both FASB and IASB cover the same topics in their
frameworks, and the two frameworks are similar. The conceptual framework helps in the standard-setting
process by creating the foundation on which those standards should be based. It can also help companies
figure out how to record transactions for which there may not currently be an applicable standard. Though there
are many similarities between the conceptual framework under US GAAP and IFRS, these similar foundations
result in different standards and/or different interpretations.
Once an accounting standard has been written for US GAAP, the FASB often offers clarification on how the
standard should be applied. Businesses frequently ask for guidance for their particular industry. When the
FASB creates accounting standards and any subsequent clarifications or guidance, it only has to consider the
effects of those standards, clarifications, or guidance on US-based companies. This means that FASB has
only one major legal system and government to consider. When offering interpretations or other guidance on
application of standards, the FASB can utilize knowledge of the US-based legal and taxation systems to help
guide their points of clarification and can even create interpretations for specific industries. This means that
interpretation and guidance on US GAAP standards can often contain specific details and guidelines in order
to help align the accounting process with legal matters and tax laws.

In applying their conceptual framework to create standards, the IASB must consider that their standards are
being used in 120 or more different countries, each with its own legal and judicial systems. Therefore, it is
much more difficult for the IASB to provide as much detailed guidance once the standard has been written,
because what might work in one country from a taxation or legal standpoint might not be appropriate in a
different country. This means that IFRS interpretations and guidance have fewer detailed components for
specific industries as compared to US GAAP guidance.

The conceptual framework sets the basis for accounting standards set by rule-making bodies that govern how the
financial statements are prepared. Here are a few of the principles, assumptions, and concepts that provide
guidance in developing GAAP.

Revenue Recognition Principle

The revenue recognition principle directs a company to recognize revenue in the period in which it is earned;
revenue is not considered earned until a product or service has been provided. This means the period of time in
which you performed the service or gave the customer the product is the period in which revenue is recognized.
There also does not have to be a correlation between when cash is collected and when revenue is recognized. A
customer may not pay for the service on the day it was provided. Even though the customer has not yet paid cash,
there is a reasonable expectation that the customer will pay in the future. Since the company has provided the
service, it would recognize the revenue as earned, even though cash has yet to be collected.
For example, Lynn Sanders owns a small printing company, Printing Plus. She completed a print job for a customer
on August 10. The customer did not pay cash for the service at that time and was billed for the service, paying at a
later date. When should Lynn recognize the revenue, on August 10 or at the later paymen
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date? Lynn should record revenue as earned on August 10. She provided the service to the customer, and
there is a reasonable expectation that the customer will pay at the later date.

Expense Recognition (Matching) Principle

The expense recognition principle (also referred to as the matching principle) states that we must match
expenses with associated revenues in the period in which the revenues were earned. A mismatch in expenses and
revenues could be an understated net income in one period with an overstated net income in another period. There
would be no reliability in statements if expenses were recorded separately from the revenues generated.
For example, if Lynn earned printing revenue in April, then any associated expenses to the revenue generation (such
as paying an employee) should be recorded on the same income statement. The employee worked for Lynn in April,
helping her earn revenue in April, so Lynn must match the expense with the revenue by showing both on the April
income statement.
Cost Principle
The cost principle, also known as the historical cost principle, states that virtually everything the company owns or
controls (assets) must be recorded at its value at the date of acquisition. For most assets, this value is easy to
determine as it is the price agreed to when buying the asset from the vendor. There are some exceptions to this
rule, but always apply the cost principle unless FASB has specifically stated that a different valuation method
should be used in a given circumstance.
The primary exceptions to this historical cost treatment, at this time, are financial instruments, such as stocks and
bonds, which might be recorded at their fair market value. This is called mark-to-market accounting or fair value
accounting and is more advanced than the general basic concepts underlying the introduction to basic accounting
concepts; therefore, it is addressed in more advanced accounting courses.
Once an asset is recorded on the books, the value of that asset must remain at its historical cost, even if its value
in the market changes. For example, Lynn Sanders purchases a piece of equipment for $40,000. She believes
this is a bargain and perceives the value to be more at $60,000 in the current market. Even though Lynn feels
the equipment is worth $60,000, she may only record the cost she paid for the equipment of $40,000.
Full Disclosure Principle
The full disclosure principle states that a business must report any business activities that could affect what is
reported on the financial statements. These activities could be nonfinancial in nature or be supplemental details not
readily available on the main financial statement. Some examples of this include any pending litigation, acquisition
information, methods used to calculate certain figures, or stock options. These disclosures are usually recorded in
footnotes on the statements, or in addenda to the statements.
Separate Entity Concept
The separate entity concept prescribes that a business may only report activities on financial statements that are
specifically related to company operations, not those activities that affect the owner personally. This concept is called
the separate entity concept because the business is considered an entity separate and apart from its owner(s)
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For example, Lynn Sanders purchases two cars; one is used for personal use only, and the other is used for
business use only. According to the separate entity concept, Lynn may record the purchase of the car used by the
company in the company’s accounting records, but not the car for personal use.

Conservatism
This concept is important when valuing a transaction for which the dollar value cannot be as clearly determined, as
when using the cost principle. Conservatism states that if there is uncertainty in a potential financial estimate, a
company should err on the side of caution and report the most conservative amount. This would mean that any
uncertain or estimated expenses/losses should be recorded, but uncertain or estimated revenues/gains should not.
This understates net income, therefore reducing profit. This gives stakeholders a more reliable view of the company’s
financial position and does not overstate income.

Monetary Measurement Concept

In order to record a transaction, we need a system of monetary measurement, or a monetary unit by which to value
the transaction. In the United States, this monetary unit is the US dollar. Without a dollar amount, it would be
impossible to record information in the financial records. It also would leave stakeholders unable to make financial
decisions, because there is no comparability measurement between companies. This concept ignores any change in
the purchasing power of the dollar due to inflation.

Going Concern Assumption

The going concern assumption assumes a business will continue to operate in the foreseeable future. A common
time frame might be twelve months. However, one should presume the business is doing well enough to continue
operations unless there is evidence to the contrary. For example, a business might have certain expenses that are
paid off (or reduced) over several time periods. If the business will stay operational in the foreseeable future, the
company can continue to recognize these long-term expenses over several time periods. Some red flags that a
business may no longer be a going concern are defaults on loans or a sequence of losses.
Time Period Assumption
The time period assumption states that a company can present useful information in shorter time periods, such
as years, quarters, or months. The information is broken into time frames to make comparisons and evaluations
easier. The information will be timely and current and will give a meaningful picture of how the company is
operating.
For example, a school year is broken down into semesters or quarters. After each semester or quarter, your grade
point average (GPA) is updated with new information on your performance in classes you completed. This gives
you timely grading information with which to make decisions about your schooling.
A potential or existing investor wants timely information by which to measure the performance of the company, and
to help decide whether to invest. Because of the time period assumption, we need to be sure to recognize revenues
and expenses in the proper period. This might mean allocating costs over more than one accounting or reporting
period.
The use of the principles, assumptions, and concepts in relation to the preparation of financial statements is better
understood when looking at the full accounting cycle and its relation to the detailed process required to record
business activities (Figure 3.2).
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Figure 3.2 GAAP Accounting Standards Connection Tree. (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

The Accounting Equation

Introduction to Financial Statements briefly discussed the accounting equation, which is important to the study of
accounting because it shows what the organization owns and the sources of (or claims against) those resources.
The accounting equation is expressed as follows:
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Recall that the accounting equation can be thought of from a “sources and claims” perspective; that is, the assets
(items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated
differently, everything a company owns must equal everything the company owes to creditors (lenders) and owners
(individuals for sole proprietors or stockholders for companies or corporations).
In our example in Why It Matters, we used an individual owner, Mark Summers, for the Supreme Cleaners
discussion to simplify our example. Individual owners are sole proprietors in legal terms. This distinction
becomes significant in such areas as legal liability and tax compliance. For sole proprietors, the owner’s interest
is labeled “owner’s equity.”
In Introduction to Financial Statements, we addressed the owner’s value in the firm as capital or owner’s equity. This
assumed that the business is a sole proprietorship. However, for the rest of the text we switch the structure of the
business to a corporation, and instead of owner’s equity, we begin using stockholder’s equity, which includes
account titles such as common stock and retained earnings to represent the owners’ interests. The primary reason
for this distinction is that the typical company can have several to thousands of owners, and the financial statements
for corporations require a greater amount of complexity.
As you also learned in Introduction to Financial Statements, the accounting equation represents the balance sheet
and shows the relationship between assets, liabilities, and owners’ equity (for sole proprietorships/ individuals) or
common stock (for companies).
You may recall from mathematics courses that an equation must always be in balance. Therefore, we must ensure
that the two sides of the accounting equation are always equal. We explore the components of the accounting
equation in more detail shortly. First, we need to examine several underlying concepts that form the foundation for
the accounting equation: the double-entry accounting system, debits and credits, and the “normal” balance for
each account that is part of a formal accounting system.

Double-Entry Bookkeeping
The basic components of even the simplest accounting system are accounts and a general ledger. An account is a
record showing increases and decreases to assets, liabilities, and equity—the basic components found in the
accounting equation. As you know from Introduction to Financial Statements, each of these categories, in turn,
includes many individual accounts, all of which a company maintains in its general ledger. A general ledger is a
comprehensive listing of all of a company’s accounts with their individual balances.
Accounting is based on what we call a double-entry accounting system, which requires the following:

Each time we record a transaction, we must record a change in at least two different accounts. Having two or
more accounts change will allow us to keep the accounting equation in balance.
Not only will at least two accounts change, but there must also be at least one debit and one credit side
impacted.
The sum of the debits must equal the sum of the credits for each transaction.

In order for companies to record the myriad of transactions they have each year, there is a need for a simple but
detailed system. Journals are useful tools to meet this need.

Debits and Credits

Each account can be represented visually by splitting the account into left and right sides as shown. This graphic
representation of a general ledger account is known as a T-account. The concept of the T-account wass
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briefly mentioned in Introduction to Financial Statements and will be used later in this chapter to analyze
transactions. A T-account is called a “T-account” because it looks like a “T,” as you can see with the T-account
shown here.

debit records financial information on the left side of each account. A credit records financial information on the
right side of an account. One side of each account will increase and the other side will decrease. The ending
account balance is found by calculating the difference between debits and credits for each account. You will often
see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr, respectively. Depending
on the account type, the sides that increase and decrease may vary. We can illustrate each account type and its
corresponding debit and credit effects in the form of an expanded accounting equation. You will learn more about the
expanded accounting equation and use it to analyze transactions in Define and Describe the Expanded Accounting
Equation and Its Relationship to Analyzing Transactions.

As we can see from this expanded accounting equation, Assets accounts increase on the debit side and
decrease on the credit side. This is also true of Dividends and Expenses accounts. Liabilities increase on the
credit side and decrease on the debit side. This is also true of Common Stock and Revenues accounts. This
becomes easier to understand as you become familiar with the normal balance of an account.

Normal Balance of an Account

The normal balance is the expected balance each account type maintains, which is the side that increases. As
assets and expenses increase on the debit side, their normal balance is a debit. Dividends paid to shareholders also
have a normal balance that is a debit entry. Since liabilities, equity (such as common stock), and revenues increase
with a credit, their “normal” balance is a credit. Table 3.1 shows the normal balances and increases for each account
type.

Account Normal Balances and Increases

Type of account Increases with Normal balance

Asset Debit Debit

Liability Credit Credit

Common Stock Credit Credit

Dividends Debit Debit

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Account Normal Balances and Increases

Type of account Increases with Normal balance

Revenue Credit Credit

Expense Debit Debit

Table 3.1

When an account produces a balance that is contrary to what the expected normal balance of that account is, this
account has an abnormal balance. Let’s consider the following example to better understand abnormal balances.

Let’s say there were a credit of $4,000 and a debit of $6,000 in the Accounts Payable account. Since Accounts
Payable increases on the credit side, one would expect a normal balance on the credit side. However, the
difference between the two figures in this case would be a debit balance of $2,000, which is an abnormal balance.
This situation could possibly occur with an overpayment to a supplier or an error in recording.

3.2 Define and Describe the Expanded Accounting Equation

and Its Relationship to Analyzing Transactions
Before we explore how to analyze transactions, we first need to understand what governs the way
transactions are recorded.
As you have learned, the accounting equation represents the idea that a company needs assets to operate, and there
are two major sources that contribute to operations: liabilities and equity. The company borrows the funds, creating
liabilities, or the company can take the funds provided by the profits generated in the current or past periods, creating
retained earnings or some other form of stockholder’s equity. Recall the accounting equation’s basic form.
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Expanded Accounting Equation

The expanded accounting equation breaks down the equity portion of the accounting equation into more detail.
This expansion of the equity section allows a company to see the impact to equity from changes to revenues and
expenses, and to owner investments and payouts. It is important to have more detail in this equity category to
understand the effect on financial statements from period to period. For example, an increase to revenue can
increase net income on the income statement, increase retained earnings on the statement of retained earnings,
and change the distribution of stockholder’s equity on the balance sheet. This may be difficult to understand where
these changes have occurred without revenue recognized individually in this expanded equation.

The expanded accounting equation is shown here.

Figure 3.3 Expanded Accounting Equation. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-
SA 4.0 license)

Note that this expanded accounting equation breaks down Equity into four categories: common stock, dividends,
revenues, and expenses. This considers each element of contributed capital and retained earnings individually to
better illustrate each one’s impact on changes in equity.
A business can now use this equation to analyze transactions in more detail. But first, it may help to examine the
many accounts that can fall under each of the main categories of Assets, Liabilities, and Equity, in terms of their
relationship to the expanded accounting equation. We can begin this discussion by looking at the chart of accounts.

Chart of Accounts
Recall that the basic components of even the simplest accounting system are accounts and a general ledger.
Accounts shows all the changes made to assets, liabilities, and equity—the three main categories in the
accounting equation. Each of these categories, in turn, includes many individual accounts, all of which a company
maintains in its general ledger.
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When a company first starts the analysis process, it will make a list of all the accounts used in day-to-day
transactions. For example, a company may have accounts such as cash, accounts receivable, supplies, accounts
payable, unearned revenues, common stock, dividends, revenues, and expenses. Each company will make a list
that works for its business type, and the transactions it expects to engage in. The accounts may receive numbers
using the system presented in Table 3.2.

Account Numbering System

Account Assigned account number Account numbers for a Account numbers for a
category will start with small company large company

Assets 1 100–199 1000–1999

Liabilities 2 200–299 2000–2999

Stockholders’ 3 300–399 3000–3999

equity

Revenues 4 400–499 4000–4999

Expenses 5 500–599 5000–5999

Table 3.2

We call this account numbering system a chart of accounts. The accounts are presented in the chart of accounts in
the order in which they appear on the financial statements, beginning with the balance sheet accounts and then the
income statement accounts. Additional numbers starting with six and continuing might be used in large
merchandising and manufacturing companies. The information in the chart of accounts is the foundation of a well-
organized accounting system.

Breaking Down the Expanded Accounting Equation

Refer to the expanded accounting equation (Figure 3.3). We begin with the left side of the equation, the assets, and
work toward the right side of the equation to liabilities and equity.

Assets and the Expanded Accounting Equation

On the left side of the equation are assets. Assets are resources a company owns that have an economic value.
Assets are represented on the balance sheet financial statement. Some common examples of assets are cash,
accounts receivable, inventory, supplies, prepaid expenses, notes receivable, equipment, buildings, machinery, and
land.
Cash includes paper currency as well as coins, checks, bank accounts, and money orders. Anything that can be
quickly liquidated into cash is considered cash. Cash activities are a large part of any business, and the flow of cash
in and out of the company is reported on the statement of cash flows.
Accounts receivable is money that is owed to the company, usually from a customer. The customer has not yet paid
with cash for the provided good or service but will do so in the future. Common phrasing to describe this situation is
that a customer purchased something “on account,” meaning that the customer has asked to be
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billed and will pay at a later date: “Account” because a customer has not paid us yet but instead has asked to be
billed; “Receivable” because we will receive the money in the future.
Inventory refers to the goods available for sale. Service companies do not have goods for sale and would thus not
have inventory. Merchandising and manufacturing businesses do have inventory. You learn more about this topic in
Inventory.
Examples of supplies (office supplies) include pens, paper, and pencils. Supplies are considered assets until an
employee uses them. At the point they are used, they no longer have an economic value to the organization, and
their cost is now an expense to the business.
Prepaid expenses are items paid for in advance of their use. They are considered assets until used. Some
examples can include insurance and rent. Insurance, for example, is usually purchased for more than one month
at a time (six months typically). The company does not use all six months of the insurance at once, it uses it one
month at a time. However, the company prepays for all of it up front. As each month passes, the company will
adjust its records to reflect the cost of one month of insurance usage.
Notes receivable is similar to accounts receivable in that it is money owed to the company by a customer or other
entity. The difference here is that a note typically includes interest and specific contract terms, and the amount
may be due in more than one accounting period.
Equipment examples include desks, chairs, and computers; anything that has a long-term value to the company that
is used in the office. Equipment is considered a long-term asset, meaning you can use it for more than one
accounting period (a year for example). Equipment will lose value over time, in a process called depreciation. You
will learn more about this topic in The Adjustment Process.
Buildings, machinery, and land are all considered long-term assets. Machinery is usually specific to a manufacturing
company that has a factory producing goods. Machinery and buildings also depreciate. Unlike other long-term
assets such as machinery, buildings, and equipment, land is not depreciated. The process to calculate the loss on
land value could be very cumbersome, speculative, and unreliable; therefore, the treatment in accounting is for land
to not be depreciated over time.
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Figure 3.4 Assets. Cash, buildings, inventory, and equipment are all types of assets. (credit clockwise from top left:
modification of “Cash money! 140606-A-CA521-021” by Sgt. Michael Selvage/Wikimedia Commons, Public Domain;
modification of “41 Cherry Orchard Road” by “Pafcool2”/Wikimedia Commons, Public Domain; modification of “ASM-
e1516805109201” by Jeff Green, Rethink Robotics/ Wikimedia Commons, CC BY 4.0; modification of “Gfp-
inventory-space” by Yinan Chen/Wikimedia Commons, CC0)

Liabilities and the Expanded Accounting Equation

The accounting equation emphasizes a basic idea in business; that is, businesses need assets in order to operate.
There are two ways a business can finance the purchase of assets. First, it can sell shares of its stock to the public
to raise money to purchase the assets, or it can use profits earned by the business to finance its activities. Second,
it can borrow the money from a lender such as a financial institution. You will learn about other assets as you
progress through the book. Let’s now take a look at the right side of the accounting equation.
Liabilities are obligations to pay an amount owed to a lender (creditor) based on a past transaction. Liabilities are
reported on the balance sheet. It is important to understand that when we talk about liabilities, we are not just talking
about loans. Money collected for gift cards, subscriptions, or as advance deposits from customers could also be
liabilities. Essentially, anything a company owes and has yet to pay within a period is considered a liability, such as
salaries, utilities, and taxes.For example, a company uses $400 worth of utilities in May but is not billed for the
usage, or asked to pay for the usage, until June. Even though the company does not have to pay the bill until June,
the company owed money for the usage that occurred in May. Therefore, the company must record the usage of
electricity, as well as the liability to pay the utility bill, in May
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Eventually that debt must be repaid by performing the service, fulfilling the subscription, or providing an asset such
as merchandise or cash. Some common examples of liabilities include accounts payable, notes payable, and
unearned revenue.Accounts payable recognizes that the company owes money and has not paid. Remember, when
a customer purchases something “on account” it means the customer has asked to be billed and will pay at a later
date. In this case the purchasing company is the “customer.” The company will have to pay the money due in the
future, so we use the word “payable.” The debt owed is usually paid off in less than one accounting period (less than
a year typically) if it is classified as an account payable.
A notes payable is similar to accounts payable in that the company owes money and has not yet paid. Some key
differences are that the contract terms are usually longer than one accounting period, interest is included, and there
is typically a more formalized contract that dictates the terms of the transaction.
Unearned revenue represents a customer’s advanced payment for a product or service that has yet to be provided
by the company. Since the company has not yet provided the product or service, it cannot recognize the customer’s
payment as revenue, according to the revenue recognition principle. Thus, the account is called unearned revenue.
The company owing the product or service creates the liability to the customer.
Equity and the Expanded Accounting Equation
Stockholder’s equity refers to the owner’s (stockholders) investments in the business and earnings. These two
components are contributed capital and retained earnings.
The owner’s investments in the business typically come in the form of common stock and are called contributed
capital. There is a hybrid owner’s investment labeled as preferred stock that is a combination of debt and equity (a
concept covered in more advanced accounting courses). The company will issue shares of common stock to
represent stockholder ownership. You will learn more about common stock in Corporation Accounting.
Another component of stockholder’s equity is company earnings. These retained earnings are what the company
holds onto at the end of a period to reinvest in the business, after any distributions to ownership occur. Stated more
technically, retained earnings are a company’s cumulative earnings since the creation of the company minus any
dividends that it has declared or paid since its creation. One tricky point to remember is that retained earnings are
not classified as assets. Instead, they are a component of the stockholder’s equity account, placing it on the right
side of the accounting equation.Distribution of earnings to ownership is called a dividend. The dividend could be paid
with cash or be a distribution of more company stock to current shareholders. Either way, dividends will decrease
retained earnings.Also affecting retained earnings are revenues and expenses, by way of net income or net loss.
Revenues are earnings from the sale of goods and services. An increase in revenues will also contribute toward an
increase in retained earnings. Expenses are the cost of resources associated with earning revenues. An increase to
expenses will contribute toward a decrease in retained earnings. Recall that this concept of recognizing expenses
associated with revenues is the expense recognition principle. Some examples of expenses include bill payments for
utilities, employee salaries, and loan interest expense. A business does not have an expense until it is “incurred.”
Incurred means the resource is used or consumed. For example, you will not recognize utilities as an expense until
you have used the utilities. The difference between revenues earned and expenses incurred is called net income
(loss) and can be found on the income statement.
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Net income reported on the income statement flows into the statement of retained earnings. If a business has net
income (earnings) for the period, then this will increase its retained earnings for the period. This means that
revenues exceeded expenses for the period, thus increasing retained earnings. If a business has net loss for the
period, this decreases retained earnings for the period. This means that the expenses exceeded the revenues for the
period, thus decreasing retained earnings.
You will notice that stockholder’s equity increases with common stock issuance and revenues, and decreases from
dividend payouts and expenses. Stockholder’s equity is reported on the balance sheet in the form of contributed
capital (common stock) and retained earnings. The statement of retained earnings computes the retained earnings
balance at the beginning of the period, adds net income or subtracts net loss from the income statement, and
subtracts dividends declared, to result in an ending retained earnings balance reported on the balance sheet.

Now that you have a basic understanding of the accounting equation, and examples of assets, liabilities, and
stockholder’s equity, you will be able to analyze the many transactions a business may encounter and determine
how each transaction affects the accounting equation and corresponding financial statements. First, however, in
Define and Examine the Initial Steps in the Accounting Cycle we look at how the role of identifying and analyzing
transactions fits into the continuous process known as the accounting cycle.

3.3 Define and Describe the Initial Steps in the Accounting Cycle

This chapter on analyzing and recording transactions is the first of three consecutive chapters (including The
Adjustment Process and Completing the Accounting Cycle ) covering the steps in one continuous process known as
the accounting cycle. The accounting cycle is a step-by-step process to record business activities and events to
keep financial records up to date. The process occurs over one accounting period and will begin the cycle again in
the following period. A period is one operating cycle of a business, which could be a month, quarter, or year.
Review the accounting cycle in Figure 3.5.
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Figure 3.5 The Accounting Cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)As you can see, the cycle begins with identifying and analyzing transactions, and culminates in reversing
entries (which we do not cover in this textbook). The entire cycle is meant to keep financial data organized and
easily accessible to both internal and external users of information. In this chapter, we focus on the first four steps
in the accounting cycle: identify and analyze transactions, record transactions to a journal, post journal information
to a ledger, and prepare an unadjusted trial balance.In The Adjustment Process we review steps 5, 6, and 7 in the
accounting cycle: record adjusting entries, prepare an adjusted trial balance, and prepare financial statements. In
Completing the Accounting Cycle, we review steps 8 and 9: closing entries and prepare a post-closing trial
balance. As stated previously, we do not cover reversing entries.

First Four Steps in the Accounting Cycle

The first four steps in the accounting cycle are (1) identify and analyze transactions, (2) record transactions to a
journal, (3) post journal information to a ledger, and (4) prepare an unadjusted trial balance. We begin by introducing
the steps and their related documentation.

Figure 3.6 Accounting Cycle. The first four steps in the accounting cycle. (attribution: Copyright Rice
University, OpenStax, under CC BY-NC-SA 4.0 license)

These first four steps set the foundation for the recording process.

Step 1. Identifying and analyzing transactions is the first step in the process. This takes information from
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original sources or activities and translates that information into usable financial data. An original source is a
traceable record of information that contributes to the creation of a business transaction. For example, a sales invoice
is considered an original source. Activities would include paying an employee, selling products, providing a service,
collecting cash, borrowing money, and issuing stock to company owners. Once the original source has been
identified, the company will analyze the information to see how it influences financial records.
Let’s say that Mark Summers of Supreme Cleaners (from Why It Matters) provides cleaning services to a customer.
He generates an invoice for $200, the amount the customer owes, so he can be paid for the service. This sales
receipt contains information such as how much the customer owes, payment terms, and dates. This sales receipt is
an original source containing financial information that creates a business transaction for the company.

Step 2 . The second step in the process is recording transactions to a journal. This takes analyzed data from step 1
and organizes it into a comprehensive record of every company transaction. A transaction is a business activity or
event that has an effect on financial information presented on financial statements. The information to record a
transaction comes from an original source. A journal (also known as the book of original entry or general journal) is a
record of all transactions.
For example, in the previous transaction, Supreme Cleaners had the invoice for $200. Mark Summers needs to
record this $200 in his financial records. He needs to choose what accounts represent this transaction, whether or
not this transaction will increase or decreases the accounts, and how that impacts the accounting equation before he
can record the transaction in his journal. He needs to do this process for every transaction occurring during the
period.
Figure 3.7 includes information such as the date of the transaction, the accounts required in the journal entry, and
columns for debits and credits.

Figure 3.7 General Journal. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Step 3. The third step in the process is posting journal information to a ledger. Posting takes all transactions from
the journal during a period and moves the information to a general ledger, or ledger. As you’ve learned, account
balances can be represented visually in the form of T-accounts.
Returning to Supreme Cleaners, Mark identified the accounts needed to represent the $200 sale and recorded them
in his journal. He will then take the account information and move it to his general ledger. All of the accounts he used
during the period will be shown on the general ledger, not only those accounts impacted by the $200 sale.
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Figure 3.8 General Ledger in T-Account Form. (attribution: Copyright Rice University, OpenStax, under CC BY-
NC-SA 4.0 license)

Step 4. The fourth step in the process is to prepare an unadjusted trial balance. This step takes information from
the general ledger and transfers it onto a document showing all account balances, and ensuring that debits and
credits for the period balance (debit and credit totals are equal).
Mark Summers from Supreme Cleaners needs to organize all of his accounts and their balances, including the $200
sale, onto a trial balance. He also needs to ensure his debits and credits are balanced at the culmination of this
step.

Figure 3.9 Unadjusted Trial Balance. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)

It is important to note that recording the entire process requires a strong attention to detail. Any mistakes early on in
the process can lead to incorrect reporting information on financial statements. If this occurs, accountants may have
to go all the way back to the beginning of the process to find their error. Make sure that as you complete each step,
you are careful and really take the time to understand how to record information and why you are recording it. In the
next section, you will learn how the accounting equation is used to analyze transactions

CONCEPTS IN PRACTICE
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Forensic Accounting
Ever dream about working for the Federal Bureau of Investigation (FBI)? As a forensic accountant, that dream
might just be possible. A forensic accountant investigates financial crimes, such as tax evasion, insider
trading, and embezzlement, among other things. Forensic accountants review financial records looking for
clues to bring about charges against potential criminals. They consider every part of the accounting cycle,
including original source documents, looking through journal entries, general ledgers, and financial
statements. They may even be asked to testify to their findings in a court of law.
To be a successful forensic accountant, one must be detailed, organized, and naturally inquisitive. This
position will need to retrace the steps a suspect may have taken to cover up fraudulent financial activities.
Understanding how a company operates can help identify fraudulent activities that veer from the company’s
position. Some of the best forensic accountants have put away major criminals such as Al Capone, Bernie
Madoff, Ken Lay, and Ivan Boesky.

3.4 Analyze Business Transactions Using the Accounting Equation and

Show the Impact of Business Transactions on Financial Statements
You gained a basic understanding of both the basic and expanded accounting equations, and looked at examples of
assets, liabilities, and stockholder’s equity in Define and Examine the Expanded Accounting Equation and Its
Relationship to Analyzing Transactions. Now, we can consider some of the transactions a business may encounter.
We can review how each transaction would affect the basic accounting equation and the corresponding financial
statements.
As discussed in Define and Examine the Initial Steps in the Accounting Cycle, the first step in the accounting cycle is
to identify and analyze transactions. Each original source must be evaluated for financial implications. Meaning, will
the information contained on this original source affect the financial statements? If the answer is yes, the company
will then analyze the information for how it affects the financial statements. For example, if a company receives a
cash payment from a customer, the company needs to know how to record the cash payment in a meaningful way to
keep its financial statements up to date.

Reviewing and Analyzing Transactions

Let us assume our business is a service-based company. We use Lynn Sanders’ small printing company, Printing
Plus, as our example. Please notice that since Printing Plus is a corporation, we are using the Common Stock
account, instead of Owner’s Equity. The following are several transactions from this business’s current month:

Issues $20,000 shares of common stock for cash.

Purchases equipment on account for $3,500, payment due within the month.
Receives $4,000 cash in advance from a customer for services not yet rendered.
Provides $5,500 in services to a customer who asks to be billed for the services.
Pays a $300 utility bill with cash.
Distributed $100 cash in dividends to stockholders.

We now analyze each of these transactions, paying attention to how they impact the accounting equation and
corresponding financial statements.
Transaction 1: Issues $20,000 shares of common stock for cash.
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Analysis: Looking at the accounting equation, we know cash is an asset and common stock is stockholder’s equity.
When a company collects cash, this will increase assets because cash is coming into the business. When a company
issues common stock, this will increase a stockholder’s equity because he or she is receiving investments from
owners.
Remember that the accounting equation must remain balanced, and assets need to equal liabilities plus equity. On
the asset side of the equation, we show an increase of $20,000. On the liabilities and equity side of the equation,
there is also an increase of $20,000, keeping the equation balanced. Changes to assets, specifically cash, will
increase assets on the balance sheet and increase cash on the statement of cash flows. Changes to stockholder’s
equity, specifically common stock, will increase stockholder’s equity on the balance sheet.

Transaction 2: Purchases equipment on account for $3,500, payment due within the month.

Analysis: We know that the company purchased equipment, which is an asset. We also know that the company
purchased the equipment on account, meaning it did not pay for the equipment immediately and asked for
payment to be billed instead and paid later. Since the company owes money and has not yet paid, this is a liability,
specifically labeled as accounts payable. There is an increase to assets because the company has equipment it
did not have before. There is also an increase to liabilities because the company now owes money. The more
money the company owes, the more that liability will increase.
The accounting equation remains balanced because there is a $3,500 increase on the asset side, and a $3,500
increase on the liability and equity side. This change to assets will increase assets on the balance sheet. The
change to liabilities will increase liabilities on the balance sheet.
Transaction 3: Receives $4,000 cash in advance from a customer for services not yet rendered.
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Analysis: We know that the company collected cash, which is an asset. This collection of $4,000 increases
assets because money is coming into the business.
The company has yet to provide the service. According to the revenue recognition principle, the company cannot
recognize that revenue until it provides the service. Therefore, the company has a liability to the customer to provide
the service and must record the liability as unearned revenue. The liability of $4,000 worth of services increases
because the company has more unearned revenue than previously.
The equation remains balanced, as assets and liabilities increase. The balance sheet would experience an
increase in assets and an increase in liabilities.
Transaction 4: Provides $5,500 in services to a customer who asks to be billed for the services.

Analysis: The customer asked to be billed for the service, meaning the customer did not pay with cash
immediately. The customer owes money and has not yet paid, signaling an accounts receivable. Accounts
receivable is an asset that is increasing in this case. This customer obligation of $5,500 adds to the balance in
accounts receivable.
The company did provide the services. As a result, the revenue recognition principle requires recognition as
revenue, which increases equity for $5,500. The increase to assets would be reflected on the balance sheet. The
increase to equity would affect three statements. The income statement would see an increase to revenues,
changing net income (loss). Net income (loss) is computed into retained earnings on the statement of retained
earnings. This change to retained earnings is shown on the balance sheet under stockholder’s equity.
Transaction 5: Pays a $300 utility bill with cash.

Analysis: The company paid with cash, an asset. Assets are decreasing by $300 since cash was used to pay for
this utility bill. The company no longer has that money.
Utility payments are generated from bills for services that were used and paid for within the accounting period,
thus recognized as an expense. The expense decreases equity by $300. The decrease to assets, specifically
cash, affects the balance sheet and statement of cash flows. The decrease to equity as a result of the expense
affects three statements. The income statement would see a change to expenses, changing net income (loss).
Net income (loss) is computed into retained earnings on the statement of retained earnings. This change to
retained earnings is shown on the balance sheet under stockholder’s equity.
Transaction 6: Distributed $100 cash in dividends to stockholders.

Analysis: The company paid the distribution with cash, an asset. Assets decrease by $100 as a result.
Dividends affect equity and, in this case, decrease equity by $100. The decrease to assets, specifically cash
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affects the balance sheet and statement of cash flows. The decrease to equity because of the dividend payout
affects the statement of retained earnings by reducing ending retained earnings, and the balance sheet by reducing
stockholder’s equity.
Let’s summarize the transactions and make sure the accounting equation has remained balanced. Shown are each
of the transactions.

As you can see, assets total $32,600, while liabilities added to equity also equal $32,600. Our accounting
equation remains balanced. In Use Journal Entries to Record Transactions and Post to T-Accounts, we add
other elements to the accounting equation and expand the equation to include individual revenue and expense
accounts

3.5 Use Journal Entries to Record Transactions and Post to T-Accounts

When we introduced debits and credits, you learned about the usefulness of T-accounts as a graphic representation
of any account in the general ledger. But before transactions are posted to the T-accounts, they are first recorded
using special forms known as journals.

Journals
Accountants use special forms called journals to keep track of their business transactions. A journal is the first place
information is entered into the accounting system. A journal is often referred to as the book of original entry
because it is the place the information originally enters into the system. A journal keeps a historical account of all
recordable transactions with which the company has engaged. In other words, a journal is similar to a diary for a
business. When you enter information into a journal, we say you are journalizing the entry. Journaling the entry is
the second step in the accounting cycle. Here is a picture of a journal.

You can see that a journal has columns labeled debit and credit. The debit is on the left side, and the credit is on
the right. Let’s look at how we use a journal.
When filling in a journal, there are some rules you need to follow to improve journal entry organization.
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Formatting When Recording Journal Entries

Include a date of when the transaction occurred.
The debit account title(s) always come first and on the left.
The credit account title(s) always come after all debit titles are entered, and on the right.
The titles of the credit accounts will be indented below the debit accounts.
You will have at least one debit (possibly more).
You will always have at least one credit (possibly more).
The dollar value of the debits must equal the dollar value of the credits or else the equation will go out of
balance.
You will write a short description after each journal entry.
Skip a space after the description before starting the next journal entry.

An example journal entry format is as follows. It is not taken from previous examples but is intended to stand alone.

Note that this example has only one debit account and one credit account, which is considered a simple entry.
compound entry is when there is more than one account listed under the debit and/or credit column of a
journal entry (as seen in the following).

Notice that for this entry, the rules for recording journal entries have been followed. There is a date of April 1, 2018,
the debit account titles are listed first with Cash and Supplies, the credit account title of Common Stock is indented
after the debit account titles, there are at least one debit and one credit, the debit amounts equal the credit amount,
and there is a short description of the transaction.
Let’s now look at a few transactions from Printing Plus and record their journal entries.
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Recording Transactions
We now return to our company example of Printing Plus, Lynn Sanders’ printing service company. We will analyze
and record each of the transactions for her business and discuss how this impacts the financial statements. Some of
the listed transactions have been ones we have seen throughout this chapter. More detail for each of these
transactions is provided, along with a few new transactions.
On January 3, 2019, issues $20,000 shares of common stock for cash.
On January 5, 2019, purchases equipment on account for $3,500, payment due within the month.
On January 9, 2019, receives $4,000 cash in advance from a customer for services not yet rendered.
On January 10, 2019, provides $5,500 in services to a customer who asks to be billed for the services.
On January 12, 2019, pays a $300 utility bill with cash.
On January 14, 2019, distributed $100 cash in dividends to stockholders.
On January 17, 2019, receives $2,800 cash from a customer for services rendered.
On January 18, 2019, paid in full, with cash, for the equipment purchase on January 5.
On January 20, 2019, paid $3,600 cash in salaries expense to employees.
On January 23, 2019, received cash payment in full from the customer on the January 10 transaction.
On January 27, 2019, provides $1,200 in services to a customer who asks to be billed for the services.
On January 30, 2019, purchases supplies on account for $500, payment due within three months.

Transaction 1: On January 3, 2019, issues $20,000 shares of common stock for cash.
Analysis:

This is a transaction that needs to be recorded, as Printing Plus has received money, and the stockholders
have invested in the firm.
Printing Plus now has more cash. Cash is an asset, which in this case is increasing. Cash increases on the
debit side.
When the company issues stock, stockholders purchase common stock, yielding a higher common stock
figure than before issuance. The common stock account is increasing and affects equity. Looking at the
expanded accounting equation, we see that Common Stock increases on the credit side.

Impact on the financial statements: Both of these accounts are balance sheet accounts. You will see total assets
increase and total stockholders’ equity will also increase, both by $20,000. With both totals increasing by $20,000, the
accounting equation, and therefore our balance sheet, will be in balance. There is no effect on the income statement
from this transaction as there were no revenues or expenses recorded.

Transaction 2: On January 5, 2019, purchases equipment on account for $3,500, payment due within the
month.
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Analysis:

In this case, equipment is an asset that is increasing. It increases because Printing Plus now has more
equipment than it did before. Assets increase on the debit side; therefore, the Equipment account would show
a $3,500 debit.
The company did not pay for the equipment immediately. Lynn asked to be sent a bill for payment at a future
date. This creates a liability for Printing Plus, who owes the supplier money for the equipment. Accounts
Payable is used to recognize this liability. This liability is increasing, as the company now owes money to the
supplier. A liability account increases on the credit side; therefore, Accounts Payable will increase on the
credit side in the amount of $3,500.

Impact on the financial statements: Since both accounts in the entry are balance sheet accounts, you will see
no effect on the income statement
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Transaction 3: On January 9, 2019, receives $4,000 cash in advance from a customer for services not yet
rendered.
Analysis:

Cash was received, thus increasing the Cash account. Cash is an asset that increases on the debit side.
Printing Plus has not yet provided the service, meaning it cannot recognize the revenue as earned. The
company has a liability to the customer until it provides the service. The Unearned Revenue account would be
used to recognize this liability. This is a liability the company did not have before, thus increasing this account.
Liabilities increase on the credit side; thus, Unearned Revenue will recognize the $4,000 on the credit side.

Impact on the financial statements: Since both accounts in the entry are balance sheet accounts, you will see
no effect on the income statement.

Transaction 4: On January 10, 2019, provides $5,500 in services to a customer who asks to be billed for the
services.
Analysis:

The company provided service to the client; therefore, the company may recognize the revenue as earned
(revenue recognition principle), which increases revenue. Service Revenue is a revenue account affecting
equity. Revenue accounts increase on the credit side; thus, Service Revenue will show an increase of $5,500
on the credit side.
The customer did not immediately pay for the services and owes Printing Plus payment. This money will be
received in the future, increasing Accounts Receivable. Accounts Receivable is an asset account. Asset
accounts increase on the debit side. Therefore, Accounts Receivable will increase for $5,500 on the debit side.
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Impact on the financial statements: You have revenue of $5,500. Revenue is reported on your income statement.
The more revenue you have, the more net income (earnings) you will have. The more earnings you have, the more
retained earnings you will keep. Retained earnings is a stockholders’ equity account, so total equity will increase
$5,500. Accounts receivable is going up so total assets will increase by $5,500. The accounting equation, and
therefore the balance sheet, remain in balance.

Transaction 5: On January 12, 2019, pays a $300 utility bill with cash.

Analysis:

Cash was used to pay the utility bill, which means cash is decreasing. Cash is an asset that decreases on the
credit side.
Paying a utility bill creates an expense for the company. Utility Expense increases, and does so on the
debit side of the accounting equation.

Impact on the financial statements: You have an expense of $300. Expenses are reported on your income
statement. More expenses lead to a decrease in net income (earnings). The fewer earnings you have, the fewer
retained earnings you will end up with. Retained earnings is a stockholders’ equity account, so total equity will
decrease by $300. Cash is decreasing, so total assets will decrease by $300, impacting the balance sheet.

Transaction 6: On January 14, 2019, distributed $100 cash in dividends to stockholders.

Analysis:

Cash was used to pay the dividends, which means cash is decreasing. Cash is an asset that decreases on
the credit side.
Dividends distribution occurred, which increases the Dividends account. Dividends is a part of
stockholder’s equity and is recorded on the debit side. This debit entry has the effect of reducing
stockholder’s equity.
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Impact on the financial statements: You have dividends of $100. An increase in dividends leads to a decrease in
stockholders’ equity (retained earnings). Cash is decreasing, so total assets will decrease by $100, impacting the
balance sheet.

Transaction 7: On January 17, 2019, receives $2,800 cash from a customer for services rendered.

Analysis:

The customer used cash as the payment method, thus increasing the amount in the Cash account. Cash is an
asset that is increasing, and it does so on the debit side.
Printing Plus provided the services, which means the company can recognize revenue as earned in the
Service Revenue account. Service Revenue increases equity; therefore, Service Revenue increases on the
credit side.

Impact on the financial statements: Revenue is reported on the income statement. More revenue will increase net
income (earnings), thus increasing retained earnings. Retained earnings is a stockholders’ equity account, so total
equity will increase $2,800. Cash is increasing, which increases total assets on the balance sheet.

Transaction 8: On January 18, 2019, paid in full, with cash, for the equipment purchase on January 5.

Analysis:Cash is decreasing because it was used to pay for the outstanding liability created on January 5. Cash is
an asset and will decrease on the credit side.
Accounts Payable recognized the liability the company had to the supplier to pay for the equipment. Since the
company is now paying off the debt it owes, this will decrease Accounts Payable. Liabilities decrease on the
debit side; therefore, Accounts Payable will decrease on the debit side by $3,500.
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Impact on the financial statements: Since both accounts in the entry are balance sheet accounts, you will see
no effect on the income statement.

Transaction 9: On January 20, 2019, paid $3,600 cash in salaries expense to employees.

Analysis:

Cash was used to pay for salaries, which decreases the Cash account. Cash is an asset that decreases on
the credit side.
Salaries are an expense to the business for employee work. This will increase Salaries Expense, affecting
equity. Expenses increase on the debit side; thus, Salaries Expense will increase on the debit side.

Impact on the financial statements: You have an expense of $3,600. Expenses are reported on the income
statement. More expenses lead to a decrease in net income (earnings). The fewer earnings you have, the fewer
retained earnings you will end up with. Retained earnings is a stockholders’ equity account, so total equity will
decrease by $3,600. Cash is decreasing, so total assets will decrease by $3,600, impacting the balance sheet.

Transaction 10: On January 23, 2019, received cash payment in full from the customer on the January 10
transaction.
Analysis:

Cash was received, thus increasing the Cash account. Cash is an asset, and assets increase on the debit
side.
Accounts Receivable was originally used to recognize the future customer payment; now that the customer
has paid in full, Accounts Receivable will decrease. Accounts Receivable is an asset, and assets decrease on
the credit side.
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Impact on the financial statements: In this transaction, there was an increase to one asset (Cash) and a decrease
to another asset (Accounts Receivable). This means total assets change by $0, because the increase and decrease
to assets in the same amount cancel each other out. There are no changes to liabilities or stockholders’ equity, so the
equation is still in balance. Since there are no revenues or expenses affected, there is no effect on the income
statement.

Transaction 11: On January 27, 2019, provides $1,200 in services to a customer who asks to be billed for the
services.
Analysis:The customer does not pay immediately for the services but is expected to pay at a future date. This
creates an Accounts Receivable for Printing Plus. The customer owes the money, which increases Accounts
Receivable. Accounts Receivable is an asset, and assets increase on the debit side.
Printing Plus provided the service, thus earning revenue. Service Revenue would increase on the credit side.

Impact on the financial statements: Revenue is reported on the income statement. More revenue will increase net
income (earnings), thus increasing retained earnings. Retained earnings is a stockholders’ equity account, so total
equity will increase $1,200. Cash is increasing, which increases total assets on the balance sheet.

Transaction 12: On January 30, 2019, purchases supplies on account for $500, payment due within three
months.
Analysis:

The company purchased supplies, which are assets to the business until used. Supplies is increasing,
because the company has more supplies than it did before. Supplies is an asset that is increasing on the
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148 Chapter 3 Analyzing and Recording Transactions

debit side.
Printing Plus did not pay immediately for the supplies and asked to be billed for the supplies, payable at a later
date. This creates a liability for the company, Accounts Payable. This liability increases Accounts Payable; thus,
Accounts Payable increases on the credit side.

Impact on the financial statements: There is an increase to a liability and an increase to assets. These
accounts both impact the balance sheet but not the income statement.

The complete journal for these transactions is as follows:

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Posting to the General Ledger

Recall that the general ledger is a record of each account and its balance. Reviewing journal entries individually can
be tedious and time consuming. The general ledger is helpful in that a company can easily extract account and
balance information. Here is a small section of a general ledger.

You can see at the top is the name of the account “Cash,” as well as the assigned account number “101.”
Remember, all asset accounts will start with the number 1. The date of each transaction related to this account is
included, a possible description of the transaction, and a reference number if available. There are debit and credit
columns, storing the financial figures for each transaction, and a balance column that keeps a running total of the
balance in the account after every transaction.
Let’s look at one of the journal entries from Printing Plus and fill in the corresponding ledgers.

As you can see, there is one ledger account for Cash and another for Common Stock. Cash is labeled account
number 101 because it is an asset account type. The date of January 3, 2019, is in the far left column, and a
description of the transaction follows in the next column. Cash had a debit of $20,000 in the journal entry, so
$20,000 is transferred to the general ledger in the debit column. The balance in this account is currently $20,000,
because no other transactions have affected this account yet.
Common Stock has the same date and description. Common Stock had a credit of $20,000 in the journal entry, and
that information is transferred to the general ledger account in the credit column. The balance at that time in the
Common Stock ledger account is $20,000.Another key element to understanding the general ledger, and the third
step in the accounting cycle, is how to calculate balances in ledger accounts.

Calculating Account Balances

When calculating balances in ledger accounts, one must take into consideration which side of the account
increases and which side decreases. To find the account balance, you must find the difference between the
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sum of all figures on the side that increases and the sum of all figures on the side that decreases.

For example, the Cash account is an asset. We know from the accounting equation that assets increase on the
debit side and decrease on the credit side. If there was a debit of $5,000 and a credit of $3,000 in the Cash account,
we would find the difference between the two, which is $2,000 (5,000 – 3,000). The debit is the larger of the two
sides ($5,000 on the debit side as opposed to $3,000 on the credit side), so the Cash account has a debit balance
of $2,000.
Another example is a liability account, such as Accounts Payable, which increases on the credit side and decreases
on the debit side. If there were a $4,000 credit and a $2,500 debit, the difference between the two is $1,500. The
credit is the larger of the two sides ($4,000 on the credit side as opposed to $2,500 on the debit side), so the
Accounts Payable account has a credit balance of $1,500.
The following are selected journal entries from Printing Plus that affect the Cash account. We will use the Cash
ledger account to calculate account balances.

The general ledger account for Cash would look like the following:
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In the last column of the Cash ledger account is the running balance. This shows where the account stands after
each transaction, as well as the final balance in the account. How do we know on which side, debit or credit, to
input each of these balances? Let’s consider the general ledger for Cash.
On January 3, there was a debit balance of $20,000 in the Cash account. On January 9, a debit of $4,000 was
included. Since both are on the debit side, they will be added together to get a balance on $24,000 (as is seen in
the balance column on the January 9 row). On January 12, there was a credit of $300 included in the Cash ledger
account. Since this figure is on the credit side, this $300 is subtracted from the previous balance of $24,000 to get a
new balance of $23,700. The same process occurs for the rest of the entries in the ledger and their balances. The
final balance in the account is $24,800.
Checking to make sure the final balance figure is correct; one can review the figures in the debit and credit columns.
In the debit column for this cash account, we see that the total is $32,300 (20,000 + 4,000 + 2,800 + 5,500). The
credit column totals $7,500 (300 + 100 + 3,500 + 3,600). The difference between the debit and credit totals is
$24,800 (32,300 – 7,500). The balance in this Cash account is a debit of $24,800. Having a debit balance in the
Cash account is the normal balance for that account.

Posting to the T-Accounts

The third step in the accounting cycle is to post journal information to the ledger. To do this we can use a T-account
format. A company will take information from its journal and post to this general ledger. Posting refers to the process
of transferring data from the journal to the general ledger. It is important to understand that T-accounts are only
used for illustrative purposes in a textbook, classroom, or business discussion. They are not official accounting
forms. Companies will use ledgers for their official books, not T-accounts.
Let’s look at the journal entries for Printing Plus and post each of those entries to their respective T-accounts.

The following are the journal entries recorded earlier for Printing Plus.

Transaction 1: On January 3, 2019, issues $20,000 shares of common stock for cash
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In the journal entry, Cash has a debit of $20,000. This is posted to the Cash T-account on the debit side (left
side). Common Stock has a credit balance of $20,000. This is posted to the Common Stock T-account on the
credit side (right side).
Transaction 2: On January 5, 2019, purchases equipment on account for $3,500, payment due within the
month.

In the journal entry, Equipment has a debit of $3,500. This is posted to the Equipment T-account on the debit side.
Accounts Payable has a credit balance of $3,500. This is posted to the Accounts Payable T-account on the credit
side.
Transaction 3: On January 9, 2019, receives $4,000 cash in advance from a customer for services not yet
rendered.
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In the journal entry, Cash has a debit of $4,000. This is posted to the Cash T-account on the debit side. You will
notice that the transaction from January 3 is listed already in this T-account. The next transaction figure of $4,000 is
added directly below the $20,000 on the debit side. Unearned Revenue has a credit balance of $4,000. This is
posted to the Unearned Revenue T-account on the credit side.
Transaction 4: On January 10, 2019, provides $5,500 in services to a customer who asks to be billed for the
services.

In the journal entry, Accounts Receivable has a debit of $5,500. This is posted to the Accounts Receivable T-account
on the debit side. Service Revenue has a credit balance of $5,500. This is posted to the Service Revenue T-account
on the credit side.
Transaction 5: On January 12, 2019, pays a $300 utility bill with cash.
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In the journal entry, Utility Expense has a debit balance of $300. This is posted to the Utility Expense T-account on
the debit side. Cash has a credit of $300. This is posted to the Cash T-account on the credit side. You will notice
that the transactions from January 3 and January 9 are listed already in this T-account. The next transaction figure
of $300 is added on the credit side.
Transaction 6: On January 14, 2019, distributed $100 cash in dividends to stockholders.

In the journal entry, Dividends has a debit balance of $100. This is posted to the Dividends T-account on the debit
side. Cash has a credit of $100. This is posted to the Cash T-account on the credit side. You will notice that the
transactions from January 3, January 9, and January 12 are listed already in this T-account. The next transaction
figure of $100 is added directly below the January 12 record on the credit side.
Transaction 7: On January 17, 2019, receives $2,800 cash from a customer for services rendered.
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In the journal entry, Cash has a debit of $2,800. This is posted to the Cash T-account on the debit side. You will
notice that the transactions from January 3, January 9, January 12, and January 14 are listed already in this T-
account. The next transaction figure of $2,800 is added directly below the January 9 record on the debit side.
Service Revenue has a credit balance of $2,800. This too has a balance already from January 10. The new entry is
recorded under the Jan 10 record, posted to the Service Revenue T-account on the credit side.
Transaction 8: On January 18, 2019, paid in full, with cash, for the equipment purchase on January 5.

On this transaction, Cash has a credit of $3,500. This is posted to the Cash T-account on the credit side beneath the
January 14 transaction. Accounts Payable has a debit of $3,500 (payment in full for the Jan. 5 purchase). You notice
there is already a credit in Accounts Payable, and the new record is placed directly across from the January 5 record.

Transaction 9: On January 20, 2019, paid $3,600 cash in salaries expense to employees.
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On this transaction, Cash has a credit of $3,600. This is posted to the Cash T-account on the credit side beneath the
January 18 transaction. Salaries Expense has a debit of $3,600. This is placed on the debit side of the Salaries
Expense T-account.
Transaction 10: On January 23, 2019, received cash payment in full from the customer on the January 10
transaction.

On this transaction, Cash has a debit of $5,500. This is posted to the Cash T-account on the debit side beneath the
January 17 transaction. Accounts Receivable has a credit of $5,500 (from the Jan. 10 transaction). The record is
placed on the credit side of the Accounts Receivable T-account across from the January 10 record.
Transaction 11: On January 27, 2019, provides $1,200 in services to a customer who asks to be billed for the
services.
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On this transaction, Accounts Receivable has a debit of $1,200. The record is placed on the debit side of the
Accounts Receivable T-account underneath the January 10 record. Service Revenue has a credit of $1,200. The
record is placed on the credit side of the Service Revenue T-account underneath the January 17 record.
Transaction 12: On January 30, 2019, purchases supplies on account for $500, payment due within three
months.

On this transaction, Supplies has a debit of $500. This will go on the debit side of the Supplies T-account.
Accounts Payable has a credit of $500. You notice there are already figures in Accounts Payable, and the new
record is placed directly underneath the January 5 record.

T-Accounts Summary
Once all journal entries have been posted to T-accounts, we can check to make sure the accounting equation
remains balanced. A summary showing the T-accounts for Printing Plus is presented in Figure 3.10.
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160 Chapter 3 Analyzing and Recording Transactions

Figure 3.10 Summary of T-Accounts for Printing Plus. (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

The sum on the assets side of the accounting equation equals $30,000, found by adding together the final balances
in each asset account (24,800 + 1,200 + 500 + 3,500). To find the total on the liabilities and equity side of the
equation, we need to find the difference between debits and credits. Credits on the liabilities and equity side of the
equation total $34,000 (500 + 4,000 + 20,000 + 9,500). Debits on the liabilities and equity side of the equation total
$4,000 (100 + 3,600 + 300). The difference $34,000 – $4,000 = $30,000. Thus, the equation remains balanced with
$30,000 on the asset side and $30,000 on the liabilities and equity side. Now that we have the T-account information,
and have confirmed the accounting equation remains balanced, we can create the unadjusted trial balance.
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YOUR TURN

Journalizing Transactions
You have the following transactions the last few days of April.

Apr. 25 You stop by your uncle’s gas station to refill both gas cans for your company, Watson’s
Landscaping. Your uncle adds the total of $28 to your account.

Apr. 26 You record another week’s revenue for the lawns mowed over the past week. You earned
$1,200. You received cash equal to 75% of your revenue.
Apr. 27 You pay your local newspaper $35 to run an advertisement in this week’s paper.
Apr. 29 You make a $25 payment on account.

Table 3.3

Prepare the necessary journal entries for these four transactions.

Explain why you debited and credited the accounts you did.
What will be the new balance in each account used in these entries?
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When constructing a trial balance, we must consider a few formatting rules, akin to those requirements for
financial statements:
The header must contain the name of the company, the label of a Trial Balance (Unadjusted), and the date.

Accounts are listed in the accounting equation order with assets listed first followed by liabilities and finally
equity.
Amounts at the top of each debit and credit column should have a dollar sign.
When amounts are added, the final figure in each column should be underscored.
The totals at the end of the trial balance need to have dollar signs and be double-underscored.

Transferring information from T-accounts to the trial balance requires consideration of the final balance in each
account. If the final balance in the ledger account (T-account) is a debit balance, you will record the total in the left
column of the trial balance. If the final balance in the ledger account (T-account) is a credit balance, you will record
the total in the right column.
Once all ledger accounts and their balances are recorded, the debit and credit columns on the trial balance are
totaled to see if the figures in each column match each other. The final total in the debit column must be the same
dollar amount that is determined in the final credit column. For example, if you determine that the final debit balance
is $24,000 then the final credit balance in the trial balance must also be $24,000. If the two balances are not equal,
there is a mistake in at least one of the columns.
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Let’s now take a look at the T-accounts and unadjusted trial balance for Printing Plus to see how the
information is transferred from the T-accounts to the unadjusted trial balance.For example, Cash has a
final balance of $24,800 on the debit side. This balance is transferred to the Cash account in the debit
column on the unadjusted trial balance. Accounts Receivable ($1,200), Supplies ($500), Equipment
($3,500), Dividends ($100), Salaries Expense ($3,600), and Utility Expense ($300) also have debit final
balances in their T-accounts, so this information will be transferred to the debit column on the unadjusted
trial balance. Accounts Payable ($500), Unearned Revenue ($4,000), Common Stock ($20,000) and
Service Revenue ($9,500) all have credit final balances in their T-accounts. These credit balances would
transfer credit column on the unadjusted trail balance.

Once all balances are transferred to the unadjusted trial balance, we will sum each of the debit and credit columns.
The debit and credit columns both total $34,000, which means they are equal and in balance. However, just because
the column totals are equal and in balance, we are still not guaranteed that a mistake is not present.

What happens if the columns are not equal?

Locating Errors
Sometimes errors may occur in the accounting process, and the trial balance can make those errors apparent when
it does not balance.
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One way to find the error is to take the difference between the two totals and divide the difference by two. For
example, let’s assume the following is the trial balance for Printing Plus.

You notice that the balances are not the same. Find the difference between the two totals: $34,100 – $33,900 = $200
difference. Now divide the difference by two: $200/2 = $100. Since the credit side has a higher total, look carefully at
the numbers on the credit side to see if any of them are $100. The Dividends account has a $100 figure listed in the
credit column. Dividends normally have a debit balance, but here it is a credit. Look back at the Dividends T-account
to see if it was copied onto the trial balance incorrectly. If the answer is the same as the T-account, then trace it back
to the journal entry to check for mistakes. You may discover in your investigation that you copied the number from
the T-account incorrectly. Fix your error, and the debit total will go up $100 and the credit total down $100 so that
they will both now be $34,000.
Another way to find an error is to take the difference between the two totals and divide by nine. If the outcome of the
difference is a whole number, then you may have transposed a figure. For example, let’s assume the following is the
trial balance for Printing Plus.
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Find the difference between the two totals: $35,800 – 34,000 = $1,800 difference. This difference divided by nine

is $200 ($1,800/9 = $200). Looking at the debit column, which has the higher total, we determine that the
Equipment account had transposed figures. The account should be $3,500 and not $5,300. We transposed the
three and the five.
What do you do if you have tried both methods and neither has worked? Unfortunately, you will have to go back
through one step at a time until you find the error.
If a trial balance is in balance, does this mean that all of the numbers are correct? Not necessarily. We can have
errors and still be mathematically in balance. It is important to go through each step very carefully and recheck
your work often to avoid mistakes early on in the process.
After the unadjusted trial balance is prepared and it appears error-free, a company might look at its financial
statements to get an idea of the company’s position before adjustments are made to certain accounts. A more
complete picture of company position develops after adjustments occur, and an adjusted trial balance has been
prepared. These next steps in the accounting cycle are covered in The Adjustment Process.

YOUR TURN

Completing a Trial Balance

Complete the trial balance for Magnificent Landscaping Service using the following T-account final
balance information for April 30, 2018.

Solution
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Key Terms
abnormal balance account balance that is contrary to the expected normal balance of that account account
record showing increases and decreases to assets, liabilities, and equity found in the accounting
equation
accounting cycle step-by-step process to record business activities and events to keep financial records up to
date
book of original entry journal is often referred to as this because it is the place the information originally enters
into the system
chart of accounts account numbering system that lists all the accounts a business uses in its day-to-day
transactions
compound entry more than one account is listed under the debit and/or credit column of a journal entry
conceptual framework interrelated objectives and fundamentals of accounting principles for financial
reporting
conservatism concept that if there is uncertainty in a potential financial estimate, a company should err on the
side of caution and report the most conservative amount
contributed capital owner’s investment (cash and other assets) in the business which typically comes in the form
of common stock
cost principle everything the company owns or controls (assets) must be recorded at its value at the date of
acquisition
credit records financial information on the right side of an account
debit records financial information on the left side of each account
double-entry accounting system requires the sum of the debits to equal the sum of the credits for each
transaction
ending account balance difference between debits and credits for an account
expanded accounting equation breaks down the equity portion of the accounting equation into more detail to see
the impact to equity from changes to revenues and expenses, and to owner investments and payouts

expense recognition principle (also, matching principle) matches expenses with associated revenues in the
period in which the revenues were generated
full disclosure principle business must report any business activities that could affect what is reported on the
financial statements
general ledger comprehensive listing of all of a company’s accounts with their individual balances
going concern assumption absent any evidence to the contrary, assumption that a business will continue to
operate in the indefinite future
journal record of all transactions
journalizing entering information into a journal; second step in the accounting cycle
monetary measurement system of using a monetary unit by which to value the transaction, such as the US dollar

normal balance expected balance each account type maintains, which is the side that increases original
source traceable record of information that contributes to the creation of a business transaction period one
operating cycle of a business, which could be a month, quarter, or year
posting takes all transactions from the journal during a period and moves the information to a general ledger
(ledger)
prepaid expenses items paid for in advance of their use
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revenue recognition principle principle stating that a company must recognize revenue in the period in which
it is earned; it is not considered earned until a product or service has been provided
separate entity concept business may only report activities on financial statements that are specifically
related to company operations, not those activities that affect the owner personally
simple entry only one debit account and one credit account are listed under the debit and credit columns of a
journal entry
stockholders‛ equity owner (stockholders‛) investments in the business and earnings
T-account graphic representation of a general ledger account in which each account is visually split into left and
right sides
time period assumption companies can present useful information in shorter time periods such as years,
quarters, or months
transaction business activity or event that has an effect on financial information presented on financial
statements
trial balance list of all accounts in the general ledger that have nonzero balances unadjusted trial
balance trial balance that includes accounts before they have been adjusted
unearned revenue advance payment for a product or service that has yet to be provided by the company; the
transaction is a liability until the product or service is provided