What is Bookkeeping and Accounting

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Chapter 1 Assets, Liabilities, and Capital In This Chapter: ✔ Nature of Accounting ✔ Basic Elements of Financial Position: The Accounting Equation ✔ Summary ✔ Solved Problems Nature of Accounting An understanding of the principles of book­ keeping and accounting is essential for anyone who is interested in a successful career in busi­ ness. The purpose of bookkeeping and account­ ing is to provide information concerning the fi­ nancial affairs of a business. This information is needed by owners, managers, creditors, and governmental agencies. An individual who earns a living by recording the financial activities of a business is known as a bookkeeper, while the process of classifying 1 Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use. 2 BOOKKEEPING AND ACCOUNTING and summarizing business transactions and interpreting their effects is accomplished by the accountant. The bookkeeper is concerned with tech­ niques involving the recording transactions, and the accountant’s objec­ tive is the use of data for interpretation. Bookkeeping and accounting techniques will both be discussed. Basic Elements of Financial Position: The Accounting Equation The financial condition or position of a business enterprise is represent­ ed by the relationship of assets to liabilities and capital. Assets: Properties that are owned and have money value—for instance, cash, inventory, buildings, equipment. Liabilities: Amounts owed to outsiders, such as notes payable, accounts payable, bonds payable. Capital: The interest of the owners in an enterprise; also known as own­ ers’ equity. These three basic elements are connected by a fundamental rela­ tionship called the accounting equation. This equation expresses the equality of the assets on one side with the claims of the creditors and owners on the other side: Assets = Liabilities + Owner’s Equity REMEMBER The accounting equation of Assets = Liabilities + Owner’s Equity should balance after every transaction. CHAPTER 1: Assets, Liabilities, and Capital 3 Example 1.1 During the month of January, Mr. Patrick Incitti, lawyer, 1. Invested 5,000 to open his law practice. 2. Bought office supplies on account, 500. 3. Received 2,000 in fees earned during the month. 4. Paid 100 on the account for the office supplies. 5. Withdrew 500 for personal use. These transactions could be analyzed and recorded as follows: Assets = Liabilities + Capital Cash Incitti, Capital 1. + 5,000 = + 5,000 Supplies Accounts Payable 2. + 500 = + 500 Cash 3. + 2,000 = Fees Income Cash + 2,000 4. − 100 = Accounts Payable Cash − 100 5. − 500 = Incitti, Capital − 500 Notice that for every transaction, two entries are made. After every trans­ action, the accounting equation remains balanced. Summary 1. The accounting equation is _______ = ________ + ________. 2. Items owned by a business that have monetary value are ______. 3. _________ is the interest of the owners in a business. 4. Money owed to an outsider is a(n) _________. 5. The difference between assets and liabilities is ___________. 6. An investment in the business increases _______ and ________. 7. To purchase “on account” is to create a ___________. 4 BOOKKEEPING AND ACCOUNTING Answers: 1. Assets, liabilities, capital; 2. Assets; 3. Capital; 4. Liability; 5. Capital; 6. Assets, capital; 7. Liability Solved Problems Solved Problem 1.1 Given any two known elements, the third can eas­ ily be computed. Determine the missing amount in each of the account­ ing equations below. Assets = Liabilities + Capital (a) 7,200 = 2,800 + ? (b) 7,000 = ? + 4,400 (c) ? = 2,000 + 4,400 (d) 20,000 = 5,600 + ? Solution: Assets = Liabilities + Capital (a) 7,200 = 2,800 + 4,400 (b) 7,000 = 2,600 + 4,400 (c) 6,400 = 2,000 + 4,400 (d) 20,000 = 5,600 + 14,400 Solved Problem 1.2 Classify each of the following as elements of the accounting equation using the following abbreviations: A = Assets; L = Liabilities; C = Capital (a) Land (b) Accounts Payable (c) Owners’ Investment (d) Accounts Receivable Solution: (a) A; (b) L; (c) C; (d) A CHAPTER 1: Assets, Liabilities, and Capital 5 Solved Problem 1.3 Determine the effect of the following transactions on capital. (a) Bought machinery on account. (b) Paid the above bill. (c) Withdrew money for personal use. (d) Inventory of supplies decreased by the end of the month. Solution: (a) No effect—only the asset and liability are affected. (b) No effect same reason. (c) Decrease in capital—capital is withdrawn. (d) Decrease in capital—supplies that are used represent an ex­ pense. Chapter 2 Debits and Credits: The Double- Entry System In This Chapter: ✔ Introduction ✔ The Account ✔ Debits and Credits ✔ The Ledger ✔ The Chart of Accounts ✔ The Trial Balance ✔ Summary ✔ Solved Problems Introduction Preparing a new equation A = L + C after each trans­ action would be cumbersome and costly, especially when there are a great many transactions in an ac­ counting period. Also, information for a specific item 6 Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use. CHAPTER 2: Debits and Credits 7 such as cash would be lost as successive transactions were recorded. This information could be obtained by going back and summarizing the trans­ actions, but that would be very time-consuming. Thus we begin with the account. The Account An account may be defined as a record of the increases, decreases, and balances in an individual item of asset, liability, capital, income (rev­ enue), or expense. The simplest form of the account is known as the “T” account be­ cause it resembles the letter “T.” The account has three parts: 1. the name of the account and the account number 2. the debit side (left side), and 3. the credit side (right side). The increases are entered on one side, the decreases on the other. The balance (the excess of the total of one side over the total of the other) is inserted near the last figure on the side with the larger amount. Debits and Credits When an amount is entered on the left side of an account, it is a debit, and the account is said to be debited. When an amount is entered on the right side, it is a credit, and the account is said to be credited. The abbrevia­ tions for debit and credit are Dr. and Cr., respectively. Whether an increase in a given item is credited or debited depends on the category of the item. By convention, asset and expense increases are recorded as debits, whereas liability, capital, and income increases are recorded as credits. Asset and expenses decreases are recorded as cred­ its, whereas liability, capital, and income decreases are recorded as deb­ its. The following tables summarize the rule. An account has a debit balance when the sum of its debits exceeds the sum of its credits; it has a credit balance when the sum of the credits is the greater. In double-entry accounting, which is in almost universal 8 BOOKKEEPING AND ACCOUNTING use, there are equal debit and credit entries for every transaction. Where only two accounts are affected, the debit and credit amounts are equal. If more than two accounts are affected, the total of the debit entries must equal the total of the credit entries. Important For every journal entry, debits must equal credits. The Ledger The complete set of accounts for a business entry is called a ledger. It is the “reference book” of the accounting system and is used to classify and summarize transactions and to prepare data for financial statements. It is also a valuable source of information for managerial purposes, giving, for example, the amount of sales for the period or the cash balance at the end of the period. The Chart of Accounts It is desirable to establish a systematic method of identify­ ing and locating each account in the ledger. The chart of accounts, sometimes called the code of accounts, is a list­ ing of the accounts by title and numerical description. In some companies, the chart of accounts may run to hundreds of items. In designing a numbering structure for the accounts, it is important to provide adequate flexibility to permit expansion without having to re­ vise the basic system. Generally, blocks of numbers are assigned to var­ ious groups of accounts, such as assets, liabilities, and so on. There are various systems of coding, depending on the needs and desires of the company. CHAPTER 2: Debits and Credits 9 The Trial Balance As every transaction results in an equal amount of debits and credits in the ledger, the total of all debit entries in the ledger should equal the to­ tal of all credit entries. At the end of the accounting period, we check this equality by preparing a two-column schedule called a trial balance, which compares the total of all debit balances with the total of all credit balances. The procedure is as follows: 1. List account titles in numerical order. 2. Record balances of each account, entering debit balances in the left column and credit balances in the right column. 3. Add the columns and record the totals. 4. Compare the totals. They must be the same. If the totals agree, the trial balance is in balance, indicating that deb­ its and credits are equal for the hundreds or thousands of transactions en­ tered in the ledger. While the trial balance provides arithmetic proof of the accuracy of the records, it does not provide theoretical proof. For ex­ ample, if the purchase of equipment was incorrectly charged to Expense, the trial balance columns may agree, but theoretically the accounts would be wrong, as Expense would be overstated and Equipment understated. In addition to providing proof of arithmetic accuracy in accounts, the tri­ al balance facilitates the preparation of the periodic financial statements. Generally, the trial balance comprises the first two columns of a work­ sheet, from which financial statements are prepared. The worksheet pro­ cedure is discussed in Chapter 8. Summary 1. To classify and summarize a single item of an account group, we use a form called an _______. 2. The accounts make up a record called a ______. 3. The left side of the account is known as the _______, while the right side of the account is known as the _________. 4. Expenses are debited because they decrease _________. 5. The schedule showing the balance of each account at the end of the period is known as the ___________. Answers: 1. account; 2. ledger; 3. debit, credit; 4. capital; 5. trial balance 10 BOOKKEEPING AND ACCOUNTING Solved Problems Solved Problem 2.1 Indicate whether the following increases and de­ creases represent a debit or credit for each particular account. (a) Capital is increased (b) Cash is decreased (c) Accounts Payable is increased (d) Rent expense is increased (e) Equipment is increased (f ) Fees income is increased (g) Capital is decreased through drawing Solution: (a) Cr. (b) Cr. (c) Cr. (d) Dr. (e) Dr. (f ) Cr. (g) Dr. Solved Problem 2.2 Rearrange the following list of accounts and pro­ duce a trial balance. Accounts Payable 9,000 General expense 1,000 Accounts Receivable 14,000 Notes Payable 11,000 Capital 32,000 Rent expense 5,000 Cash 20,000 Salaries expense 8,000 Drawing 4,000 Supplies 6,000 Equipment 18,000 Supplies expense 2,000 Fees income 26,000 Solution: Dr. Cr. Cash 20,000 Accounts Receivable 14,000 Supplies 6,000 Equipment 18,000 Accounts Payable 9,000 Notes Payable 11,000 Capital 32,000 Drawing 4,000 Fees Income 26,000 CHAPTER 2: Debits and Credits 11 Salaries expense 8,000 Rent expense 5,000 Supplies expense 2,000 General expense 1,000 78,000 78,000 Chapter 3 Journalizing and Posting Transactions In This Chapter: ✔ Introduction ✔ The Journal ✔ Journalizing ✔ Posting ✔ Summary ✔ Solved Problems Introduction In the preceding chapters, we discussed the na­ ture of business transactions and the manner in which they are analyzed and classified. The pri­ mary emphasis was the “why” rather than the “how” of accounting operations; we aimed at an understanding of the reason for making the entry in a particular way. We showed the effects of transactions by making entries in T accounts. However, these entries do not provide the necessary data for a particular transaction, nor do they provide a chronological record of transactions. 12 Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use. CHAPTER 3: Journalizing and Posting Transactions 13 The missing information is furnished by the use of an accounting form known as the journal. The Journal The journal, or day book, is the book of original entry for accounting data. Afterward, the data is transferred or posted to the ledger, the book of sub­ sequent or secondary entry. The various transactions are evidenced by sales tickets, purchase invoices, check stubs, and so on. On the basis of this evidence, the transactions are entered in chronological order in the journal. The process is called journalizing. A number of different journals may be used in a business. For our purposes, they may be grouped into general journals and specialized jour­ nals. The latter type, which are used in businesses with a large number of repetitive transactions, are described in Chapter 6. To illustrate journal­ izing, we here use the general journal, whose standard form is shown be­ low. Journalizing We describe the entries in the general journal according to the number­ ing in the table above: 1. Date. The year, month, and day of the first entry are written in the date column. The year and month do not have to be repeated for the ad­ ditional entries until a new month occurs or a new page is needed. 2. Description. The account title to be debited is entered on the first line, next to the date column. The name of the account to be credited is entered on the line below and indented. 3. P.R. (Posting Reference). Nothing is entered in this column until the particular entry is posted, that is, until the amounts are transferred to 14 BOOKKEEPING AND ACCOUNTING the related ledger accounts. The posting process will be described in the next section. 4. Debit. The debit amount for each account is entered in this col­ umn. Generally, there is only one item, but there could be two or more separate items. 5. Credit. The credit amount for each account is entered in this col­ umn. Here again, there is generally only one account, but there could be two or more accounts involved with different amounts. 6. Explanation. A brief description of the transaction is usually made on the line below the credit. Generally, a blank line is left between the ex­ planation and the next entry. Posting The process of transferring information from the journal to the ledger for the purpose of summarizing is called posting and is ordinarily carried out in the following steps: 1. Record the amount and date. The date and the amounts of the deb­ its and credits are entered in the appropriate accounts. 2. Record the posting reference in the account. The number of the journal page is entered in the account Summary 1. To classify and summarize a single item of an account group, we use a form called an _______. 2. The accounts make up a record called a ______. 3. The left side of the account is known as the _______, while the right side of the account is known as the _________. 4. Expenses are debited because they decrease _________. 5. The schedule showing the balance of each account at the end of the period is known as the ___________. Answers: 1. account; 2. ledger; 3. debit, credit; 4. capital; 5. trial balance CHAPTER 3: Journalizing and Posting Transactions 15 Solved Problems Solved Problem 3.1 Below each entry, write a brief explanation of the transaction that might appear in the general journal. (a) Equipment 10,000 Cash 2,000 Accounts Payable 8,000 (b) Accounts Payable 8,000 Notes Payable 8,000 (c) Notes Payable 8,000 Cash 8,000 Solution: (a) purchase of equipment, 20% for cash, balance on account (b) notes payable in settlement of accounts payable (c) settlement of notes payable Solved Problem 3.2 Dr. Patrick Wallace began his practice, investing in the business the following assets: Cash 12,000 Supplies 1,400 Equipment 22,600 Furniture 10,000 Record the opening entry in the journal. Solution: Cash 12,000 Supplies 1,400 Equipment 22,600 Furniture 10,000 P. Wallace, Capital 46,000 Solved Problem 3.3 If, in Solved Problem 3.2, Dr. Wallace owed a bal­ ance of 3,500 on the equipment, what would the opening entry be? 16 BOOKKEEPING AND ACCOUNTING Solution: Cash 12,000 Supplies 1,400 Equipment 22,600 Furniture 10,000 Accounts Payable 3,500 P. Wallace, Capital 42,500 Chapter 4 Financial Statements In This Chapter: ✔ Introduction ✔ Income Statement ✔ Accrual Basis and Cash Basis of Accounting ✔ Balance Sheet ✔ Capital Statement ✔ Classified Financial Statements ✔ Summary ✔ Solved Problems Introduction The two principal questions that the owner of a business asks periodical­ ly are: 1. What is my net income (profit)? 2. What is my capital? The simple balance of assets against liabilities and capital provided by the accounting equation is insufficient to give complete answers. For the first, we must know the type and amount of income and the type and 17 Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use. 18 BOOKKEEPING AND ACCOUNTING amount of each expense for the period in question. For second, it is necessary to obtain the type and amount of each asset, liability, and capital account at the end of the period. The information to answer the first question is provided by the income statement, and information to an­ swer the second comes from the balance sheet. Note Each heading of a financial statement answers the questions “who,” “what,” and “when.” Income Statement The income statement may be defined as a summary of the revenue (in­ come), expenses, and net income of a business entity for a specific peri­ od of time. This may also be called a profit and loss statement, an oper­ ating statement, or a statement of operations. Let us review the meanings of the elements entering into the income statement. Revenue. The increase in capital resulting from the delivery of goods or rendering of services by the business. In amount, the revenue is equal to the cash and receivables gained in compensation for the goods delivered or services rendered. Expenses. The decrease in capital caused by the business’s revenue-pro- ducing operations. In amount, the expense is equal to the value of goods and services used up or consumed in obtaining revenue. Net income. The increase in capital resulting from profitable operation of a business; it is the excess of revenue over expenses for the accounting period. It is important to note that a cash receipt qualifies as revenue only if it serves to increase capital. Similarly, a cash payment is an expense only CHAPTER 4: Financial Statements 19 if it decreases capital. Thus, for instance, borrowing cash from a bank does not contribute to revenue. In many companies, there are hundreds and perhaps thousands of in­ come and expense transactions in a month. To lump all these transactions under one account would be very cumbersome and would, in addition, make it impossible to show relationships among the various items. To solve this problem, we set up a temporary set of income and expense ac­ counts. The net difference of these accounts, the net profit or net loss, is then transferred as one figure to the capital account. Don’t Forget The income statement is also known as a profit and loss statement, an op­ erating statement, or a statement of operations. Accrual Basis and Cash Basis of Accounting Because an income statement pertains to a definite period of time, it be­ comes necessary to determine just when an item of revenue or expense is to be accounted for. Under the accrual basis of accounting, revenue is recognized only when it is earned and expense is recognized only when it is incurred. This differs significantly from the cash basis of accounting, which recognizes revenue and expense generally with the receipt and payment of cash. Essential to the accrual basis is the matching of ex­ penses with the revenue that they helped produce. Under the accrual sys­ tem, the accounts are adjusted at the end of the accounting period to prop­ erly reflect the revenue earned and the cost and expenses applicable to the period. Most business firms use the accrual basis, whereas individuals and professional people generally use the cash basis. Ordinarily, the cash ba­ sis is not suitable when there are significant amounts of inventories, re­ ceivables, and payables.

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