LEARNING OBJECTIVES

After studying Chapter 2, you should be able to:

1. Describe common types of accounts
2. Record the impact of business transactions on the accounting equation
3. Record business transactions in T-accounts
4. Record business transactions in the journal and post them to the ledger
5. Prepare a trial balance

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OBJECTIVE 1: Describe common types of accounts
A. Account – a basic component of an accounting system which is used to record all of the
transactions (increases and decreases) affecting a particular asset, liability, or element of
shareholders’ equity. Accounts are grouped based on the accounting equation, A (Assets) = L
(Liabilities) + SHE (Shareholders Equity).

B. Assets – economic resources that benefit a business now, or will be of benefit to the business
in the future. Cash, receivables, inventory, prepaid expenses, land, building, equipment,
furniture and fixtures, are examples of assets.

C. Liabilities – debts or other obligations of the business that must be satisfied in the future.
Accounts and notes payable, salary payable, taxes payable, interest payable, and other
accrued liabilities are all examples of liabilities.

D. Shareholders’ Equity – owners’ (investors’) claims on assets owned by the corporation.

Share capital, retained earnings, dividends, revenues, expenses, gains and losses are all
shareholders’ equity accounts. Another similar term is “owners’ equity.”

E. Revenues – income earned from performing services or selling products. Revenues increase
net income and retained earnings and thus increase shareholders’ equity.

F. Expenses – costs incurred in operating a business. Expenses decrease net income and
retained earnings and decrease shareholders’ equity, which is just the opposite effect of
revenues.

G. Gains – another form of income that usually occurs outside the course of a company’s
ordinary business activities which increase net income and retained earnings.

H. Losses – another form of expense that usually occurs outside the course of a company’s
ordinary business activities which decreases net income and retained earnings.

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OBJECTIVE 2: Record the impact of business transactions on the accounting equation

A. A business transaction is an event that affects the financial position of a business and may be
reliably recorded.

B. Business transactions are analyzed according to their effect on the accounting equation. The
accounting equation must balance after each transaction is recorded. A=L+SHE

1. Owners’ investment of cash increases both assets and shareholders’ equity.

2. Purchase of an asset for cash increases assets and decreases assets (no effect on total
assets).
3. Purchase of an asset on credit (on account) increases both assets and liabilities.
4. Receipt of cash for service revenue increases both assets and shareholders’ equity.
5. Performance of services on account increases both assets and shareholders’ equity.
6. Cash payment of expenses decreases both assets and shareholders’ equity.
7. Payment on account decreases both assets and liabilities.
8. Personal transactions of the owner do not affect the business, per the separate-entity
assumption.
9. Collection of cash on account increases assets and decreases assets.
10. Sale of an asset at a price equal to its cost increases assets and decreases assets.
11. Declaration and payment of cash dividends decreases both assets and shareholders’
equity.

Four different ways the term “on account” is used in transactions:

1. Performed services on account means Accounts Receivable increases
2. Collected on account means Accounts Receivable decreases
3. Purchased on account means Accounts Payable increases
4. Paid on account means Accounts Payable decreases

D. Data that flow from statement to statement.

1. The income statement reports net income or net loss for the period (revenues minus
expenses equals net income; if expenses exceed revenues, a net loss is reported).
2. The statement of retained earnings reports the change in retained earnings starting with
the beginning balance of retained earnings, adding net income (from the income
statement), deducting dividends and obtaining the ending balance of retained earnings.
3. The balance sheet reflects the accounting equation (A=L+SHE) at the end of the period,
proving that assets = liabilities + shareholders’ (owners’) equity. Included in the
shareholders’ equity section of the balance sheet is ending retained earnings (from the
statement of retained earnings).

Income Statement: Revenues – Expenses = Net Income (or Loss)

Statement of Retained Earnings: bbRetained Earnings + Net Income – Dividends =
ebRetained Earnings (where bb and eb stand for beginning balance and ending balance
respectively)
Balance Sheet: Assets = Liabilities + Shareholders’ Equity

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OBJECTIVE 3: Record business transactions in T-accounts

A. Accounting is a double-entry system that reports the dual effects, giving and receiving, of all
business transactions. Each transaction affects at least two (or more) accounts.

B. The chart of accounts lists all the accounts and their account numbers (in numerical order).
Accounts are numbered beginning with assets, then liabilities, shareholders’ equity, revenues
and finally expenses; accounts in the ledger are always in this same order. Exhibit 2-3
illustrates a chart of accounts.

C. The T-account (as it resembles the Capital letter `T`) is an abbreviated form of an account,
used to help illustrate the effect of transactions. The vertical line divides the account into left
(debit) and right (credit) sides.

Account Name
Debit entries Credit entries
(left side) (right side)

D. Every account balance is derived from four components:

1. Beginning balance
2. + Increases
3. -Decreases
4. = Ending balance

For example, if cash at the beginning of the period is $2,000, cash receipts during the period
total $26,000, and cash disbursements are $25,000, then ending cash is $3,000. If you know
any three of the four components, you can calculate the fourth. You can also see these
relationships by recording this information in a T-account for Cash.

E. The type of account determines the side on which increases and decreases are recorded; the
rules of debit and credit keep the accounting equation in balance. The accounting equation
and the rules of debit and credit are illustrated in Exhibit 2-4. Exhibits 2-5 demonstrates the
use of T-accounts. After each transaction is recorded, the accounting equation must remain in
balance, as illustrated in Exhibit 2-6.

The double-entry system requires that the debit side equals the credit side so that the accounting
equation stays in balance. Debit and credit terminology used by banks should not be confused
with the rules of debit and credit which include:
Debit = left side of an account
Credit = right side of an account

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 1. Increases in assets are recorded on the left (debit) side of the account. Decreases in
assets are recorded on the right (credit) side. This is the left side of the accounting
equation or Assets.
2. Rules for liabilities and shareholders’ equity accounts are the opposite of the rules for
assets. Increases in liabilities and shareholders’ equity accounts are recorded on
the right (credit) side of an account, and decreases are recorded on the left (debit)
side. This is the right side of the accounting equation or Liabilities + Shareholders’
Equity.

The following “normal balance T-account” may be helpful in applying the rules of debit and
credit.
Normal Balances

Assets Liabilities
Expenses Revenues
Dividends Common Shares
Retained Earnings

H. Often, a shift of a balance amount away from its normal column indicates there has been an
accounting error.

Every transaction involves both a debit and a credit, and the total amount debited in a transaction
must always equal the total amount credited. After increases and decreases in an account are
recorded, the amount remaining in the account is its balance. All account balances are computed
by adding the beginning balance and the increases, and subtracting the decreases. (The balance
equals the difference between total debit entries and total credit entries.)

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OBJECTIVE 4: Record business transactions in the journal and post them to the ledger

A. Transactions are recorded first in the journal, a chronological listing of all the entity’s
business transactions.

B. The recording process follows three steps:

1. Identify the transaction from the source document, such as a sales invoice or check stub.
a. Specify each account affected
b. Classify each account by type such as asset or expense
2. For the accounts involved
a. Determine which accounts increase and which decrease. (Some transactions may
require only increases or only decreases.)
b. Apply the rules of debit and credit
3. Record the transaction in the journal, listing the debit first followed by the credit.
The debit side is entered on the left margin, and the credit side is indented to the right.
Verify that total debits equal total credits and provide a brief explanation of the
transaction. A journal entry would appear as follows:

Account Name XX (debit amount)

Account Name XX (credit amount)
Brief explanation of the transaction.

A logical sequence of steps must be followed when recording transactions: analyze (determine the
accounts affected and whether the accounts increase or decrease), apply rules of debit and credit,
journalize the entry, and include an explanation.
For each identified transaction:

What accounts are involved?

For each account:

What kind of account (asset, liability, owners’ equity (investment, drawing/dividend, revenue,
expense) is it?
Is that account increasing or decreasing as a result of the transaction?
Given the type of account and the increase/decrease is it a debit or a credit?

C. The journal gives more information than a ledger account provides because it shows the
complete effect of each transaction, not just one part of it.

D. The journal entry should always include a brief explanation of the transaction.

E. Ledger – a group of accounts. All of the accounts of a business grouped together form a book
called the ledger (or general ledger). The correct order of accounts is assets, liabilities, and
then shareholders’ equity.

Why do we use two records, the journal and the ledger? Businesses need both a chronological
record of transactions (the journal) and a record of each account’s activity and its balance (the
ledger). Both are necessary to ensure that data are reported accurately.

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F. Posting – the process of copying (transferring) data from the journal to accounts in the
ledger.
1. Debits in the journal are posted as debits to the appropriate accounts; credits in the
journal are posted as credits to the appropriate accounts.
2. All transactions must be keyed by date or number to provide a link between the journal
and the ledger. (Exhibits 2-9 and 2-10 illustrate the flow of accounting information, from
journalizing the original entry to posting it to the accounts in the ledger.)
3. Exhibit 2-11 shows how ledger accounts appear after a series of transactions have been
posted and account balances calculated.

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OBJECTIVE 5: Prepare a trial balance

A. The trial balance is a listing, in general ledger order (assets, liabilities, then shareholders’
equity), of the debit or credit balance in each account as illustrated in Exhibit 2-12.

The trial balance is not one of the four financial statements, but merely a report to aid
the accountant in the preparation of the financial statements. You may also want to
point out that the kinds of errors detected by a trial balance are the kinds of errors that
humans make frequently but computers make very infrequently.

B. The total debits must equal the total credits. Unequal column totals indicate at least one error.
Some common errors are:
1. Posting incorrectly.
2. Mathematical errors.
a. Transposition means digits are written in the wrong order. (For example, instead of
$567, the number is written as $657.) A transposition error is always evenly divisible
by 9 ($657 - $567 = $90, which is divisible by 9= 10)
b. A slide means that one or more zeroes are added to, or left off, a number ($1,000 is
written as $100). A slide is always evenly divisible by 9.
3. Omitting or entering account balances in the wrong column of the trial balance. Divide an
out of account balance by 2 and then look for a transaction involving the exact amount
computed.

C. Equal trial balance totals prove only that debits posted to accounts equal credits posted to
accounts; it does not prove that the trial balance does not have errors and that it is correct.
Errors in transactions that have equal debits and credits will not be revealed by unequal totals.

Here is one way to look for possible errors on a trial balance. Refer to Exhibit 2-12. Assume that
Dividends of $2,100 are erroneously listed in the credit column on the trial balance.
Recalculate the trial balance totals. (Debit column = $59,700. Credit column = $63,900.) To find
the mistake, calculate the difference between the column totals and divide that amount by two:
$63,900 - $59,700 = $4,200; $4,200/2 = $2,100.

D. Decision Guidelines for analyzing and recording transactions, and reporting are presented.

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 CHAPTER 2

Circle the letter of the best response.

1. Which of these is (are) an example of an expense account?

A. Service Revenue
B. Dividends
C. Cost of Goods Sold
D. All of the above are expenses

2. Muin Corporation paid $ 500 on account. The effect of this transaction on Muin’s accounting
equation is to:
A. decrease liabilities and increase shareholders’ equity.
B. decrease assets and decrease liabilities.
C. has no effect on total assets.
D. decrease assets and decrease shareholders’ equity.

3. Which of these statements is true?

A. Decreases in liabilities and increases in revenues are recorded with a credit.
B. Decreases in assets and increases in shareholders’ equity are recorded with a debit.
C. Increases in both assets and expenses are recorded with a credit.
D. Increases in assets and decreases in liabilities are recorded with a debit.

4. Note receivable has a normal beginning balance of $40,200. During the period, new
borrowings total $100,000 and payments on loans total $20,600. Determine the correct ending
balance in Note Receivable.
A. $39,200, debit
B. $119,600, credit
C. $39,200, credit
D. $119,600, debit

5. Which of these statements is correct?

A. The account is a basic summary device used in accounting.
B. A business transaction is recorded first in the ledger and then posted to the journal.
C. In the journal entry, all accounts that are increased are listed first and then all accounts that are
decreased are listed next.
D. Both A and B are correct.

6. Which of these accounts has a normal credit balance?

A. Salary Expense
B. Accounts Payable
C. Service Revenue
D. Both B and C

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7. The December 31 trial balance reports a credit balance of $5,000 for Service Revenue. During
the month, one entry for $1,000 had been posted in error as a debit, instead of as a credit, to
Service Revenue. What is the correct balance of Service Revenue at December 31?
A. $4,000
B. $5,000
C. $6,000
D. $7,000

8. The beginning Cash account balance is $ 8,700. During the period, cash payments totalled
$44,600. If ending Cash is $ 1,100, then cash receipts must have been:
A. $35,500
B. $37,000
C. $35,900
D. $34,800

9. Use the following selected information to calculate the correct credit column total for a trial
balance:
Accounts receivable $ 27,200
Accounts payable 15,000
Building 359,600
Cash 55,600
Common shares 120,000
Dividends 4,800
Insurance expense 1,800
Retained earnings 33,800
Salary expense 52,500
Salary payable 3,600
Service revenue 193,200

A. $365,600
B. $304,700
C. $501,500
D. $506,300

10. The journal entry to record the performance of services for $1,200 cash is:
A. Service Revenue 1,200
Cash 1,200
B. Accounts Receivable 1,200
Service Revenue 1,200
C. Cash 1,200
Service Revenue 1,200
D. Service Revenue 1,200
Accounts Payable 1,200

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ANSWER KEY
1. C
2. B
3. D
4. D
5. A
6. D
7. D
8. B
9. A
10. C

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