3-1

Chapter

3
The Accounting Cycle
Capturing Economic Events

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-2

Learning Objective

To identify the steps in

the accounting cycle
and discuss the role of
accounting records in
an organization.

LO1
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-3

The Role of Accounting Records

Establishes accountability for
assets and transactions.

Keeps track of routine

business activities.

Obtains detailed information

about a particular transaction.

Evaluates efficiency and

performance within company.

Maintains evidence of a
company’s business activities.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-4

Learning Objective

To describe a ledger
account and a ledger.

LO2
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-5

The Ledger

Accounts are
Cash individual records
showing increases
Accounts
and decreases.
Payable
The entire group of
Capital accounts is kept
Stock together in an
accounting record
called a ledger.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-6

The Use of Accounts

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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-7

Let’s see how

debits and credits
are recorded in the
Cash account for
JJ’s Lawn Care
Service.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-8

Debit and Credit Entries

Cash
Receipts 5/1 8,000 5/2 2,500 Payments
are on 5/25 75 5/8 2,000 are on the
the debit credit
side.
5/29 750 5/28 150
side.
5/31 50
5/31 4,125 The balance is the
Bal. difference between
the debit and credit
entries in the
account.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-9

Learning Objective

To understand how
balance sheet accounts
are increased and
decreased.

LO3
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-10

Debit and Credit Rules

Debits and credits affect accounts as follows:

A = L + OE
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
for for for for for for
Increase Decrease Decrease Increase Decrease Increase

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-11

Learning Objective

To explain the double-

entry system of
accounting.

LO4
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-12

Double Entry Accounting ⎯ The Equality

of Debits and Credits

A = L + OE
Debit Credit
=
balances balances

In the double-entry accounting system,

every transaction is recorded by equal
dollar amounts of debits and credits.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-13

Let’s record
selected
transactions for
JJ’s Lawn Care
Service in the
accounts.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-14

 May 1: Jill Jones and her family invested $8,000

in JJ’s Lawn Care Service and received 800 shares
of stock.

Will Capital Stock

Will Cash increase
increase or
or decrease?
decrease?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-15

 May 1: Jill Jones and her family invested $8,000

in JJ’s Lawn Care Service and received 800 shares
of stock.

Capital Stock
Cash increases
increases $8,000
$8,000 with a debit.
with a credit.

Cash Capital Stock

5/1 8,000 5/1 8,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-16
 May 2: JJ’s purchased a riding lawn mower
for $2,500 cash.

Will Tools &

Will Cash increase
Equipment increase
or decrease?
or decrease?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-17
 May 2: JJ’s purchased a riding lawn mower
for $2,500 cash.

Tools & Equipment

Cash decreases
increases $2,500
$2,500 with a credit.
with a debit.

Cash Tools & Equipment

5/1 8,000 5/2 2,500 5/2 2,500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-18
 May 8: JJ’s purchased a $15,000 truck. JJ’s
paid $2,000 in cash and issued a note payable
for the remaining $13,000.

Will Cash and

Will Truck increase Notes Payable
or decrease? increase or
decrease?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-19
 May 8: JJ’s purchased a $15,000 truck. JJ’s
paid $2,000 in cash and issued a note payable
for the remaining $13,000.

Cash decreases
$2,000 with a credit.
Truck increases
Notes Payable
$15,000 with a debit.
increases $13,000
with a credit.

Cash
5/1 8,000 5/2 2,500
Truck
5/8 2,000
5/8 15,000
Notes Payable
5/8 13,000
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-20
 May 11: JJ’s purchased some repair parts
for $300 on account.

Will Tools & Will Accounts

Equipment increase Payable increase or
or decrease? decrease?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-21
 May 11: JJ’s purchased some repair parts
for $300 on account.

Tools & Equipment Accounts Payable

increases $300 with increases $300 with
a debit. a credit.

Tools & Equipment Accounts Payable

5/2 2,500 5/11 300
5/11 300

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-22
 May 18: JJ’s sold half of the repair parts to
ABC Lawns for $150, a price equal to JJ’s cost.
ABC Lawns agrees to pay JJ’s within 30 days.

Will Tools & Will Accounts

Equipment increase Receivable increase
or decrease? or decrease?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-23
 May 18: JJ’s sold half of the repair parts to
ABC Lawns for $150, a price equal to JJ’s cost.
ABC Lawns agrees to pay JJ’s within 30 days.

Tools & Equipment Accounts Receivable

decreases $150 with increases $150 with
a credit. a debit.

Tools & Equipment Accounts Receivable

5/2 2,500 5/18 150 5/18 150
5/11 300

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-24

Learning Objective

To explain the purpose

of a journal and its
relationship to the
ledger.

LO5
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-25

The Journal

In an actual accounting system, transactions

are initially recorded in the journal.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2007
May 1 Cash 8,000
Capital Stock 8,000
Owners invest cash in the business.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-26

Posting Journal Entries to the Ledger

Accounts

Posting
involves
copying
information
from the
journal to the
ledger
accounts.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-27

Posting Journal Entries to the Ledger

Accounts

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2007
May 1 Cash 8,000
Capital Stock 8,000
Owners invest cash in the business.
General Ledger
Cash
Date Debit Credit Balance
2007
May 1 8,000 8,000
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-28

Posting Journal Entries to the Ledger

Accounts

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2007
May 1 Cash 8,000
Capital Stock 8,000
Owners invest cash in the business.
General Ledger
Capital Stock
Date Debit Credit Balance
2007
May 1 8,000 8,000
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-29

Posting Journal Entries to the Ledger

Accounts

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

2007
May 2 Tools & Equipment 2,500
Cash 2,500
Purchased lawn mower.

Let’s see what the cash account looks like after

posting the cash portion of this transaction for
JJ’s Lawn Care Service.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-30

Ledger Accounts After Posting

General Ledger
Cash
Date Debit Credit Balance
2007
May 1 8,000 8,000
2 2,500 5,500

This ledger format is referred to as a

running balance.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-31

Ledger Accounts After Posting

General Ledger
Cash
Date Debit Credit Balance
2007
May 1 8,000 8,000
2 2,500 5,500

T accounts are simplified versions of

the ledger account that only show the
debit and credit columns.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-32

Learning Objective

To explain the nature of

net income, revenue,
and expenses.

LO6
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-33

What is Net Income?

Net income is not an asset ⎯ it’s an increase in

owners’ equity from profits of the business.

A = L + OE
Increase Decrease Increase

Either (or both) of these . . . but this is

effects occur as net income what “net income”
is earned . . . really means.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-34

Retained Earnings

A = L + OE
Capital Retained
Stock Earnings

The balance in the Retained Earnings account represents

the total net income of the corporation over the entire
lifetime of the business, less all amounts which have
been distributed to the stockholders as dividends.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-35

The Income Statement: A Preview

JJ's Lawn Care Service
Income Statement
For the Month Ended May 31, 2007

Sales Revenue $ 750

Operating Expense:
Gasoline Expense 50
Net Income $ 700

The income statement summarizes the profitability

of a business for a specified period of time.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-36

Accounting Periods

Time Period Principle

To provide users of financial
statements with timely
information, net income is
measured for relatively short
accounting periods of equal
length.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-37

Revenue and Expenses

The price for
goods sold
and services Increases
rendered during a owners’ equity.
given accounting
period.

The costs of
goods and Decreases
services used up owner’s equity.
in the process of
earning revenue.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-38

Learning Objective

To apply the realization

and matching principles
in recording revenue
and expenses.

LO7
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-39
The Realization Principle: When To
Record Revenue

Realization Principle
Revenue should be
recognized at the
time goods are sold
and services are
rendered.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-40
The Matching Principle: When To
Record Expenses

Matching Principle
Expenses should be
recorded in the
period in which they
are used up.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-41
Debits and Credits for Revenue and
Expense

Expenses EQUITIES Revenues

decrease Debit Credit increase
owners’ for for owners’
equity. Decrease Increase equity.

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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-42

Investments by and Payments to

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

DIVIDENDS CAPITAL STOCK

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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-43

Learning Objective

To understand how
revenue and expense
transactions are
recorded in an
accounting system.

LO8
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-44

Let’s analyze the

revenue and
expense
transactions for
JJ’s Lawn Care
Service for the
month of May.
We will also
analyze a dividend
transaction.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-45
 May 29: JJ’s provided lawn care services for
a client and received $750 in cash.

Will Sales Revenue

Will Cash increase
increase or
or decrease?
decrease?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-46
 May 29: JJ’s provided lawn care services for
a client and received $750 in cash.

Sales Revenue
Cash increases
increases $750 with
$750 with a debit.
a credit.

Cash Sales Revenue

5/1 8,000 5/2 2,500 5/29 750
5/29 750 5/8 2,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-47
 May 31: JJ’s purchased gasoline for the lawn
mower and the truck for $50 cash.

Will Gasoline
Will Cash increase
Expense increase or
or decrease?
decrease?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-48
 May 31: JJ’s purchased gasoline for the lawn
mower and the truck for $50 cash.

Gasoline Expense
Cash decreases $50
increases $50 with a
with a credit.
debit.

Cash Gasoline Expense

5/1 8,000 5/2 2,500 5/31 50
5/29 750 5/8 2,000
5/31 50

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-49
 May 31: JJ’s Lawn Care paid Jill Jones and
her family a $200 dividend.

Will Dividends
Will Cash increase
increase or
or decrease?
decrease?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-50
 May 31: JJ’s Lawn Care paid Jill Jones and
her family a $200 dividend.

Cash decreases Dividends increase

$200 with a credit. $200 with a debit.

Cash Dividends
5/1 8,000 5/2 2,500 5/31 200
5/29 750 5/8 2,000
5/31 50
5/31 200

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-51

Learning Objective

To prepare a trial
balance and explain its
uses and limitations.

LO9
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-52

Now, let’s look at

the Trial Balance
for JJ’s Lawn Care
Service for the
month of May.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 3-53

All balances
JJ's Lawn Care Service
are taken from
Unadjusted Trial Balance
the ledger
May 31, 2007
Cash $ 3,925
accounts on
Accounts receivable 75 May 31 after
Tools & equipment 2,650 considering all
Truck 15,000 of JJ’s
Notes payable $ 13,000 transactions
Accounts payable 150 for the month.
Capital stock 8,000
Dividends 200 Proves equality
Sales revenue 750 of debits and
Gasoline expense 50 credits.
Total $ 21,900 $ 21,900
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-54

Learning Objective

To distinguish between
accounting cycle
procedures and the
knowledge of
accounting.

LO10
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-55

The Accounting Cycle

Make end-of-
Journalize year
Post entries to Prepare trial
transactions. adjustments.
the ledger balance.
accounts.

Prepare after-closing Journalize and Prepare Prepare adjusted

trial balance. post closing financial trial balance.
McGraw-Hill/Irwin entries. statements.© The McGraw-Hill Companies, Inc., 2008
 3-56

End of Chapter 3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008