Chapter 4

Accounting
Records and
Systems

McGraw-Hill/Irwin Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

 Chapter Overview

• No new concepts introduced.

• Recordkeeping fundamentals.
– Focus on manual system because easier to
visualize.
• Why? Accounting is best learned by
doing.
• Debit-credit mechanism provides an
analytical framework.
4-2
 The Account

• Device used for calculating net change in

an item (e.g., cash, inventory, wage
expense).
• Simplest form is T-account.
• Increases listed on one side; decreases
listed on other side (Note: Which side
depends on type of account).
4-3
 Permanent Accounts

• Also called real accounts or balance

sheet accounts.
• Reported on balance sheet.
• Carried forward into next period:
– In this sense, they are permanent.

4-4
 Temporary Accounts

• Revenue and expense accounts.

• Helps summarize operating activity.
• Avoids cluttering retained earnings
account.
• Why temporary?
– At end of accounting period, balances are
transferred to retained earnings.
– Therefore, balances at beginning are zero.
4-5
 General Ledger

• General ledger contains all accounts.

• Some accounts may be in summary form.
– E.g., accounts receivable, inventory, fixed
assets.
– Detail or subsidiary ledgers kept for above.

4-6
 Chart of Accounts
• List of all accounts.
• Numbers assigned to accounts to make
summaries for Balance Sheet and Income
Statement easier.
• Management determines number of
accounts based on information needs.
• May be several levels of detail.
• Can view as building blocks summarized
in various ways.
4-7
 Debit and Credit
• Left hand side of an account
arbitrarily called debit side.
• Right hand side is credit side. Account Name
Debit Credit
• To “debit” is to record on
left hand side.
• To “credit” is to record on
right hand side.

4-8
 Fundamental Accounting
Equation
Assets = Liabilities + Owners’ Equity
Debit Credit Debit Credit Debit Credit

• For each transaction:

• dr. (debit) = cr. (credit).
• Assets = Liabilities + Owners’ Equity.
• Thus, double-entry bookkeeping.

4-9
 Fundamental Accounting
Equation
Assets = Liabilities + Owners’ Equity
Debit Credit Debit Credit Debit Credit
+ - - + - +

• Increase (decrease) assets with debit (credit).

• Increase (decrease) liabilities and owners’
equity with credit (debit).
• Why opposite? Maintain equality of
accounting equation.
4-10
 Revenues and Expenses
Revenues Expenses
Debit Credit Debit Credit
- + + -

• Revenues and expenses can be viewed as extension

of retained earnings (owners’ equity).
• Increase (decrease) revenues with credit (debit).
• Increase (decrease) expenses with debit (credit).
• Why?
• Revenues increase retained earnings.
• Expenses decrease retained earnings. 4-11
 Summary of
Accounting Process (Cycle)
1. Analyze transactions.
2. Journalize original entries.
• Record chronologically in journal.
3. Post journal entries to ledger.
• Organize by account.
4. Identify, journalize, and post adjusting entries.
• Per matching concept.
5. Journalize and post closing entries.
• Close out temporary accounts.
6. Prepare financial statements.
4-12
 Transaction Analysis

• Determine dual effect on accounts.

• Assets = Liabilities + Owners’ Equity.
• dr. (debit) = cr. (credit).
• Advice: Record half of entry that is more
obvious.

t-13
 Examples
Owner invests $5,000 in business.
Cash Paid-In Capital
Debit Credit Debit Credit
+ - - +
$5,000 $5,000

Business pays $750 for rent.

Cash Prepaid Expenses
Debit Credit Debit Credit
+ - + -
$5,000 $750 $750

4-14
 Trial Balance
• Prepare after original entries are journalized
and then posted to ledger.
• List of all accounts and their ending balance.
– Assets (debit balance).
– Liabilities (credit balance).
– Owners’ equity (credit balance).
– Revenues (credit balance).
– Expenses (debit balance).

4-15
 Trial Balance

• Why prepare?
– Shows equality of debits and credits (i.e.,
maintained integrity of accounting
equation).
• But still could be errors.
– Convenient summary for making
adjusting entries and preparing financial
statements.

4-16
 Adjusting Entries
• Modifies account balances at end of period
to fairly reflect financial situation.
• Types:
– Recorded costs related to two or more periods
(e.g., insurance, depreciation).
– Unrecorded expenses (e.g., employee wages,
bad debts).
– Recorded revenues related to two or more
periods (e.g., rent revenue).
– Unrecorded revenues (e.g., interest earned).
4-17
 Adjusting Entry for Insurance
• Business purchases two year insurance policy on
Jan 1 for $1,600.
Prepaid Insurance Cash
Debit Credit Debit Credit
Original
Entry
+ - + -
$1,600 $1,600

Insurance Expense Prepaid Insurance

Adjusting Debit Credit Debit Credit
Entry + - + -
$800 $1,600 $800
4-18
 Adjusting Entry for Depreciation
• Business purchases $10,000 of equipment on Jan 1.
Has useful life of 5 years, $0 salvage value.
Equipment Cash
Debit Credit Debit Credit
Original
Entry
+ - + -
$10,000 $10,000

Depreciation Expense Accumulated Depreciation

Adjusting Debit Credit Debit Credit
Entry + - - +
$2,000 $2,000
4-19
 Adjusting Entry for Bad Debts
• Business makes $10,000 of sales on credit.
Estimates $300 will be uncollectible.
Accounts Receivable Sales Revenues
Debit Credit Debit Credit
Original
Entries
+ - - +
$10,000 $10,000

Allowance for
Bad Debt Expense Doubtful Accounts

Adjusting Debit Credit Debit Credit

Entry + - - +
$300 $300
4-20
 Closing Entries
• Temporary (i.e., income statement) accounts
are closed out to the Income Summary.
– Clearing account.
– Also called Profit & Loss, Expense and Revenue
Summary.
– Result is zero balance in temporary accounts.
• Income summary account is then closed out
to Retained Earnings.
– Only permanent accounts will then have balances.
4-21
 Financial Statement
Preparation
• Income Statement.
– Balances in temporary accounts prior to
closing, or
– Debits and credits to Income Summary
accounts.
• Balance Sheet.
– Balances in permanent accounts.

4-22
 Objectives of Accounting
System
• Process information efficiently (i.e., low
cost).
• Obtain reports quickly.
• Ensure a high degree of accuracy.
• Minimize possibility of theft or fraud.

4-23
 Internal Accounting Controls
• Basic principle: Make it difficult (as is
practical) for people to be dishonest or
careless.
• Activities that reduce possibility of theft, or
intentional or unintentional mistakes.
– Accuracy checks (e.g., trial balance, bank
reconciliation).
– Segregation of duties (i.e., record keeping,
custody of assets, authorization of
transactions).
4-24
 Computer-Based Accounting
Systems
• Performs some or all bookkeeping
(mechanical) steps:
– Records and stores data.
– Performs arithmetic operations on data.
– Sorts and summarizes data.
– Prepares reports.
• More efficient than manual systems.
• Off-the-shelf systems available for small
companies.
4-25
 Computer-Based Accounting
Systems
• Inputs.
– Manually entered or scanned in.
• Processing.
– Chance for errors reduced (e.g., only
accept entries if debits equal credits).
• Outputs.
– Tables, graphs, etc.
– Routine or customized.
4-26
 Computer-Based Accounting
Systems
• Modules.
– Interconnected software programs.
– Examples:
• Order entry module (i.e., processes sales
orders, records shipments, records accounts
receivable).
• Purchasing module (i.e., issues purchase
orders, tracks inventory, records accounts
payable).
• Payroll and personnel records.
4-27
 Computer-Based Accounting
Systems
• Potential problems.
– Modifying to unique complexities of a
company may be costly.
– Paper trail replaced by electronic
records.
– Technological advances can make
systems obsolete.
– Challenge of educating users.

4-28