Chapter Two

The Accounting Cycle

2.1. Financial Statements:

The Starting Point in the Study of Accounting

The preparation of financial statements is not the first step in the accounting
process, but it is a logical point to begin the study of accounting. Financial
statements are the end product of the accounting process.
In this chapter, we shall explore the nature of the balance sheet, or statement
of financial position, as it is often called. Once we have become familiar with
the form and arrangement of the balance sheet and with the meanings of
technical terms such as assets, liabilities, and owners equity, it will be as easy
to read and understand a report on the financial position of a business.
The Balance Sheet
The purpose of the balance sheet is to show the financial position of a given
business entity at a specific date. Every business prepares a balance sheet at
the end of the year. The balance sheet date is important as the financial
position of a business may change quickly.
The following balance sheet shows the financial position of Selam Travel
Agency, incorporation, at December 31, 2014.

Selam Travel Agency, INC.

Balance Sheet
December 31, 2014
Assets Liabilities & Stockholders” Equity
Cash ……………………………… $ 40,500 Liabilities:
Notes Receivable ……….……. 50,000 Notes Payable ……………… $ 26,000
Accounts Receivable ……….. 62,500 Accounts Payable ………... 36,000
Supplies …………………………. 2,000 Income tax Payable ……… 18,000
Land ……………………………… 100,000 Total Liabilities …….……. $ 80,000
Building …………………………. 90,000 Stockholders” Equity:
Office Equipment ….………... 5,000 Capital Stock ……$ 225,000
Retained Earnings.…45,000 270,000
Total …………………………… $ 350,000 Total ……………………………… $ 350,000

Let us briefly discuss several features of this balance sheet. First, the heading
sets forth three things: (1) the name of the business entity, (2) the name of the
financial statement, and (3) the balance sheet date.
The body of the balance sheet also consists of three distinct sections: assets,
liabilities, and stockholders’ equity.

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Notice that cash is listed first among the assets, followed by receivables,
supplies, and any other assets that will soon be converted into cash or
consumed on operations. Following these relatively “liquid” assets are the
more “permanent” assets, such as land, buildings, and equipment.
Finally, notice that the amount of total assets ($350,000) is equal to the total
amount of liabilities and owners equity (also $350,000). This relationship
always exists – in fact; the equality of these totals is the reason that this
financial statement is called the balance sheet.
Assets
Assets are economic resources that are owned by a business and are expected
to benefit future operations. Assets may have definite physical form such as
buildings, machinery, or an inventory of merchandise. On the other hand,
some assets exist not in physical or tangible form, but in the form of valuable
legal claims or rights; examples are amounts due from customers,
investments in government bonds, and patent rights.
Liabilities
Liabilities are debts. The person or organization to whom the debt is owed is
called a creditor. All businesses have liabilities; even the largest and most
successful companies often purchase merchandise, supplies, and services “on
account.” The liabilities arising from such purchases are called accounts
payable. Many businesses borrow money to finance expansion or the purchase
of high-cost assets. When making a loan, the borrower usually must sign a
formal note payable. A note payable is a written promise to pay the amount
owed by a particular date, and usually calls for the payment of interest as well.
Accounts payable, in contrast to notes payable, involves no written promises
and generally do not call for interest payments. In essence, a note payable is a
more formal arrangement. The order in which short term liabilities are listed
is not important. Creditors’ claims have priority over those of owners. This
means that creditors are entitled to be paid in full, even if such payment
should exhaust the assets of the business and leave nothing for its owners.
Owners” Equity
The owners’ equity in a corporation is called stockholders’ equity. Owners’
equity represents the owners’ claim to the assets of the business. Because
creditors claim have legal priority over those of the owners, owners’ equity is a
residual amount. Owners’ are entitled to what is left after the claims of the
creditors have been satisfied in full. Therefore owners’ equity is always equal to
total assets minus total liabilities.

Increases in owners’ equity:

The owners’ equity in a business comes from two sources:
1. Investment by the owners
2. Earnings from profitable operation of the business

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Decreases in owners’ equity:
Deceases in the owners’ equity also are caused in two ways:
1. Distribution of cash or other assets by the business to its owners
(termed dividends)
2. Losses from unprofitable operation of the business

Owners’ equity in Corporations and Unincorporated Businesses

The owners’ equity of a corporation consists of two elements: capital stock and
retained earnings, as shown in the following illustration:

Owners’ Equity in Selam Travel Agency, Inc. – a Corporation

Stockholders” Equity:
Capital Stock ………………….. $ 225,000
Retained Earnings .………….. 45,000
Total Stockholders’ equity …………. $270,000

The $225,000 shown in capital stock represents the amount invested in the
business by its owners. The $45,000 of retained earnings represents the
portion of owners’ equity which has been accumulated through profitable
operation of the business. The term retained earnings describes only the
earnings which were not paid out in the form of dividends.

In contrast, a sole proprietorship is not required to maintain a distinction

between invested capital and earned capital. Consequently, the balance of a
sole proprietorship will have only one item in the owner’s section, as illustrated
below:

Owner’s Equity if Selam Travel Agency were a Sole proprietorship

Owner’s Equity:
Fisseha Belay, capital ………………….. $ 270,000

The equity section for a business organized as a partnership is similar to that

of a sole proprietorship, except that a separate owner’s capital account is
shown for each person.

What is a Capital Stock?

As previously mentioned, the caption capital stock in the balance sheet of a
corporation represents the amount invested in a business by its owners. When
the owners of a corporation invest cash or other assets in the business, the
corporation issues in exchange shares of capital stock as evidence of the
investor’s ownership equity. Thus, the owners of a corporation are termed
stockholders/ shareholders.

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The basic unit of capital stock is called a share, but a corporation may issue
capital stock certificate in denomination of 1 share, 100 shares, or any other
number. The total number of shares of capital stock outstanding (in the hand
of stockholders) at any given time represent 100% ownership of the
corporation. The number of shares owned by an individual investor determines
the extent of his or her ownership of the corporation.
2.2. The Accounting Equation
A fundamental characteristic of every balance sheet is that the total figures for
assets always equal the total of liabilities plus owners’ equity. This agreement
or balance of total assets with the total of liabilities plus owners’ equity is one
reason for calling this financial statement a “balance” sheet. But why do total
assets equal the total of liabilities and owners’ equity? The answer can be given
in one short paragraph.
The dollar totals on the two sides of the balance sheet are always equal
because these two sides are merely two views of the same business property.
The listing of assets shows us what things the business own;
The listing of liabilities and owners’ equity tells us who supplied these
resources to the business and how much each group supplied.
Everything the business owns has been supplied to it by the creditors or by the
owners. Therefore, the total claims of the creditors plus the claims of the
owners equal the total assets of the business.
The equality of assets on the one hand and of the claims on the creditors and
the owners on the other hand is expressed in the following accounting
equation:

Assets = Liabilities + Owners’ Equity

$350,000 = $80,000 + $270,000

2.3. Effects of Business Transaction

Assume that Pat Reed and Chris Lee start a real estate business. They
organize the business as a corporation, called Greenhill Real Estate. The
business will assist homeowners and investors in purchasing and selling real
estate, and will also manage properties owned by investors.

As a first step, Reed and Lee obtain a charter from the State Commissioner
of the Corporations, establishing Greenhill Real State as a legal corporate
entity. The state authorizes the new corporation to issue 8,000 shares of
capital stock. On October 1, Greenhill issue all of its capital stock to Reed
and Lee at a price of $10 per share. Reed invests $45,000 and receives a stock
certificate for 4,500 shares of capital stock; Lee invests $35,000 in exchange for
3,500 shares. Greenhill deposits the entire $80,000 received from Reed and Lee
in its bank account.

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The issuance of capital stock provides Greenhill with an asset. Cash, and also
creates owners’ equity in the business. A balance sheet showing the
company’s financial position after this initial transaction appears below:

GREENHILL REAL ESTATE

Balance Sheet
October 1, 20___
Assets Stockholders” Equity:
Cash ……………………………… $ 80,000 Capital Stock ………………. $ 80,000

Purchase of an Asset for Cash:

Greenhill’s next transaction is to purchase land as a site for an office. On
October 3, the corporation buys a parcel of land for $52,000. Greenhill pays
the entire purchase in cash, as banks usually do not make loans for purchases
of vacant land.
This transaction has two immediate effects upon Greenhill’s position: First
cash is decreased by $52,000; and second, anew asset, Land, is acquired. A
balance sheet prepared immediately after this transaction appears below:

GREENHILL REAL ESTATE

Balance Sheet
October 3, 20___
Assets Stockholders” Equity:
Cash ……………………………… $ 28,000 Capital Stock ………………. $ 80,000
Land ……………………………… 52,000 _____
Total ……………………………… $ 80,000 Total …………………………… $ 80,000

Purchase of an Asset and Financing Part of the Cost:

On October 5, Greenhill purchases a small building that must be moved to
permit construction of a freeway. The purchase price is $36,000. Which
includes the cost of moving the building and installing it on Greenhill’s land.
Greenhill pays $6,000 of the purchase price in cash and issues a 60-day non-
interest bearing note payable to Ramirez Demolition Co. for the $30,000
balance.
As result of this purchase, Greenhill has (1) a new asset, Building, which cost
$36,000; (2) a new liability, Notes Payable, in the amount of $30,000.; and (3)
$6,000 less cash. The company’s financial position at October 5 is:

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 GREENHILL REAL ESTATE
Balance Sheet
October 5, 20___
Assets Liabilities & Stockholders” Equity
Cash ……………………………… $ 22,000 Liabilities:
Land ……………………………… 52,000 Notes Payable ……………… $ 30,000
Building ……………….………… 36,000
Stockholders” Equity:
________ Capital Stock …..……………. $ 80,000
Total ……………. ……………… $ 110,000 Total …………………..………… $ 110,000

Purchase of an Asset “on Account”:

On October 17, Greenhill purchases office equipment on account from
Business Warehouse. The purchase price is $13,800, due in 30 days.
Greenhill’s financial position following this transaction is:

GREENHILL REAL ESTATE

Balance Sheet
October 17, 20___
Assets Liabilities & Stockholders” Equity
Cash ……………………………… $ 22,000 Liabilities:
Land ……………………………… 52,000 Notes Payable ……..………. $ 30,000
Building ……………….………… 36,000 Accounts Payable ……… 13,800
Office Equipment ……….…..… 13,800 Total Liabilities …….……. $ 43,800

Stockholders” Equity:
________ Capital Stock …..……………. $ 80,000
Total ………………….………… $ 123,800 Total ……………..…..………… $ 123,800

Sale of an Asset:
After taking delivery of the office equipment, Greenhill found that it had
purchased more than its needs. Village Animal Hospital, a neighboring
business, offers to buy the excess items. On October 20, Greenhill sells several
pieces of office equipment to Village animal Hospital for $1,800, a price equal
to Greenhill’s cost. Village makes no down payment, but agrees to pay the
amount owed within 30 days. The effect of this transaction upon Greenhill’s
position appears below:

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 GREENHILL REAL ESTATE
Balance Sheet
October 20, 20___
Assets Liabilities & Stockholders” Equity
Cash ……………………………… $ 22,000 Liabilities:
Accounts Receivable ………. 1,800 Notes Payable ……..………. $ 30,000
Land ……………………………… 52,000 Accounts Payable ……… 13,800
Building ……………….………… 36,000 Total Liabilities …….……. $ 43,800
Office Equipment ……….…..… 12,000
Stockholders” Equity:
________ Capital Stock …..……………. $ 80,000
Total ………………….………… $ 123,800 Total ……………..…..………… $ 123,800

Collection of Account Receivable:

On October 25, Greenhill receives $600 from Village Animal Hospitals a partial
settlement of its accounts receivable from Village Animal Hospital. This
transaction causes an increase in cash, but a decrease of the same amount in
accounts receivable. In essence, this transaction merely converts one asset into
another of equal value; there is no change in the amount of total assets. After
this transaction, Greenhill’s financial position may be summarized as follows:

GREENHILL REAL ESTATE

Balance Sheet
October 25, 20___
Assets Liabilities & Stockholders” Equity
Cash ……………………………… $ 22,600 Liabilities:
Accounts Receivable ………. 1,200 Notes Payable ……..………. $ 30,000
Land ……………………………… 52,000 Accounts Payable ……… 13,800
Building ……………….………… 36,000 Total Liabilities …….……. $ 43,800
Office Equipment ……….…..… 12,000
Stockholders” Equity:
______ Capital Stock …..……………. $ 80,000
Total ………………….………… $ 123,800 Total ……………..…..………… $ 123,800

Payment of Liability:
On the last day of October, Greenhill makes a partial payment of $6,800 on
its accounts payable to Business Warehouse. This transaction reduces
Greenhill’s cash and accounts payable by the same amount, leaving total
assets and total liabilities plus stockholders equity “in balance.” Greenhill’s
balance sheet at October 31 appears below:

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 GREENHILL REAL ESTATE
Balance Sheet
October 31, 20___
Assets Liabilities & Stockholders” Equity
Cash ……………………………… $ 15,800 Liabilities:
Accounts Receivable ………. 1,200 Notes Payable ……..………. $ 30,000
Land ……………………………… 52,000 Accounts Payable ……… 7,000
Building ……………….………… 36,000 Total Liabilities …….……. $ 37,000
Office Equipment ……….…..… 12,000
Stockholders” Equity:
________ Capital Stock …..……………. $ 80,000
Total ……………….………… $ 117,000 Total ……………..…..………… $ 117,000

October was a month devoted exclusively to organizing the business and not
to income-producing activities. In the next discussion and chapters we shall
continue the example of Greenhill Real Estate by illustrating operating
transactions and considering how the net income of the business can be
determined.

Effects of Business Transactions upon the Accounting Equation

The balance sheet is merely a detailed expression of the accounting equation:
Assets = Liabilities + Owners’ Equity
In the preceding pages, we have illustrated the effects of Greenhill’s October
transactions upon the balance sheet. Let us now illustrate the effects of
these transactions upon the accounting equation.
To review, Greenhill’s transactions during October were as follows:
Oct. 1 Issued capital stock in exchange for $80,000 cash.
Oct. 3 Purchased land for $52,000, paying cash.
Oct. 5 Purchased a building for $36,000, paying $6,000 in cash and
issuing a note payable for the remaining $30,000.
Oct. 17 Purchased $13,800 of office equipment on account.
Oct. 20 Sold part of the office equipment at a price equal to its cost of
$1,800, collectible within 30 days.
Oct. 25 Received $600 in partial collection of the amount receivable
from the sale of office equipment.
Oct. 31 Paid $6,800 in partial payment of an account payable.

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 Effects of Business Transactions upon the Accounting Equation
The balance sheet is merely a detailed expression of the accounting equation:
Assets = Liabilities + Owners’ Equity
In the preceding pages, we have illustrated the effects of Greenhill’s October transactions upon the balance sheet. Let us now
illustrate the effects of these transactions upon the accounting equation.
To review, Greenhill’s transactions during October were as follows:
Oct. 1 Issued capital stock in exchange for $80,000 cash.
Oct. 3 Purchased land for $52,000, paying cash.
Oct. 5 Purchased a building for $36,000, paying $6,000 in cash and issuing a note payable for the remaining $30,000.
Oct. 17 Purchased $13,800 of office equipment on account.
Oct. 20 Sold part of the office equipment at a price equal to its cost of $1,800, collectible within 30 days.
Oct. 25 Received $600 in partial collection of the amount receivable from the sale of office equipment.
Oct. 31 Paid $6,800 in partial payment of an account payable.
The table below shows the effects of these transactions upon the accounting equation. Notice that the accounting equation always
remains ‘in balance’.
Assets = Liabilities + Owners’ Equity
Accounts Office Notes Accounts Capital
Cash + Receivable + Land + Building + Equipment Payable + Payable + Stock
Oct.1 $80,000 $80,000
Balance $80,000 $80,000
Oct.3 -52,000 +52,000 -
Balance $28,000 $52,000 $80,000
Oct.5 -6,000 - +36,000 +30,000 -
Balance $22,000 $52,000 $36,000 $30,000 $80,000
Oct.17 - - - +13,800 - +13,800 -
Balance $22,000 $52,000 $36,000 $13,800 $30,000 $13,800 $80,000
Oct.20 - +1,800 - - -1,800 - - -
Balance $22,000 $1,800 $52,000 $36,000 $12,000 $30,000 $13,800 $80,000
Oct.25 +600 -600 - - - - - -
Balance $22,600 $1,200 $52,000 $36,000 $12,000 $30,000 $13,800 80,000
Oct.31 -6,800 - - - - - -6,800 -
Balance $15,800 $1,200 $52,000 $36,000 $12,000 $30,000 $7,000 $80,000

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 2.4. Recording Changes in Financial Position

2.4.1. The Role of Accounting Records

Businesses do not prepare new financial statements after every transaction.
Rather, they accumulate the effects of individual business transactions in their
accounting records. Then, at regular intervals, the data in these records are
used to prepare financial statements, income tax returns, and other types of
accounting reports.
But the need for accounting reports is not the only reason businesses maintain
accounting records. Managers and employees of the business frequently use
these records for such purposes as:
1. Establishing accountability for the assets and/or transactions under
the individual’s control.
2. Keeping track of routine business activities – such as the amount of
money in company’s bank accounts, amount due from credit customers,
amount owed to suppliers.
3. Obtaining detail information about a particular transaction.
4. Evaluating the efficiency and performance of various departments
within the organization.
5. Maintaining documentary evidence of the company’s business
activities.
In this chapter, we explain the double-entry system of accounting and
illustrate the “flow” of data through basic accounting records.
Our examples are based upon the October transactions of Greenhill Real
Estate.
The Ledger
An accounting system includes a separate record for each item that
appears in the balance sheet. For example, a separate record is kept for for
the asset cash, showing all increases and decreases in cash resulting from the
many transactions in which cash is received or paid. A similar record is kept
for every other asset, every liability, and for owners’ equity.
The record used to keep track of the increases and decreases in a single
balance sheet item is termed a ledger account, or simply an account. The
entire group of accounts is kept together in an accounting record called a
ledger.

The Use of Ledger Accounts

A ledger account is a means of accumulating in one place all the information
about changes in a specific asset, liability, or owners’ equity. For example, a
ledger account for the asset cash provides a record of the amount of cash

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receipts, cash payments, and the current cash balance. By maintaining a cash
account, management can keep track of the amounts of cash available for
meeting payrolls and for making current purchases of assets or services. This
record of cash is also useful in planning future operations and in advance
planning of applications for bank loans.
In its simplest form, an account has only three elements: (1) a title,
consisting of the name of the particular asset, liability, or owners’ equity; (2) a
left side, which is called the debit side; and a right side, which is called the
credit side.
This form of account, illustrated below is called a T account because of its
resemblance to the letter T. more complete forms of accounts will be illustrated
later.
Title of Account

Left or Right or

Debit side Credit side

Debit and Credit Entries

An amount recorded on the left or debit side of an account is called a debit, or

a debit entry; an amount entered on the right side or credit side is called a
credit, or a credit entry. Accountants also use the words debit and credit as
verbs. The act of recording a debit in an account is called debiting the account;
the recording of a credit is called crediting the account.
Accountants use debit to mean an entry on the left hand side of an account
and credit to mean an entry on the right-hand side. Thus, debit and credit
simply mean left and right, without any hidden implications.
To illustrate the records of debits and credits in an account, let us go back to
five cash transactions of Greenhill real Estate described before. When these
cash transactions are recorded in an account, the receipts are listed in vertical
order on the debit side of the account and the payments are listed on the credit
side.
The dates of the transactions may also be listed, as shown in th following
illustration:
Cash

10/1 80,000 10/3 52,000

10/25 600 10/5 6,000
10/30 6,800
80,600 64,800
-----------------------------------------------------------------------
10/31 Balance 15,800

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Each debit and credit entry in the cash account represents a cash receipt or a
cash payment. The amount of cash owned by the business at a given date is
equal to the balance of the account on that date.

Determining the Balance of a T account

The balance of a ledger account is the difference in dollars between the total
debits and the total credits in the account. If the debit total exceeds the credit
total, the account has a debit balance; if the credit total exceeds the debit
total, the account has a credit balance.
In our illustration cash account, a rule has been drawn across the account
following the last cash transaction recorded on October. The total cash receipts
(debits) recorded in October amount to $80,600, and the total cash payments
(credits) amount to $64,800. These totals, called footings, are entered in small-
size figures just above the rule. (Notice that these footings are written to the
left of the regular money columns so that they will not be mistaken for debit
and credit entries.) By subtracting the credit totals from the debit totals
($80,600 - $64,800), we determine that the Cash account has a debit balance
of $15,800 on October 31.
This debit balance is entered in the debit side of the account just below the
rule. In effect, the horizontal rule creates a “fresh start” in our T account, with
the month ending balance representing the net result of all the previous debit
and credit entries. The Cash account now shows the amount of cash owned by
the business on October 31. In a balance sheet prepared at this date, cash in
the amount of $15,800 would be listed as an asset.
Debit Balances in Asset Account
In the preceding illustration of a cash account, increases were recorded on the
left or debit side of the account and decreases were recorded on the right or
credit side. The increases were greater than the decreases and the result was a
debit balance in the account.
All asset accounts normally have debit balances. It is hard to imagine an
account for an asset such as land having credit balance, as this would indicate
that the business had disposed of more land than it had ever acquired. (For
other assets, such as cash, it is possible to acquire a credit balance – but such
balances are only temporary.)
The fact that assets are located on the left side of the balance sheet is a
convenient means of remembering the rule that an increase in an asset is
recorded on the left (debit) side of the account, and also that an asset account
normally has a debit (left-hand) balance.

Any Asset Account

Debit Credit
(representing (representing
an increase) a decrease)

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Credit Balances in Liability & Owners’ Equity Accounts
Increases in Liability & Owners’ Equity Accounts are recorded by credit entries
and decreases in these accounts are recorded by debits. The relationship
between entries in these accounts and their position on the balance sheet may
be summed up as follows:
(1) Liabilities and owners’ equity belong on the right side of the balance
sheet,
(2) An increase in a liability or an owners’ equity account is recorded on the
right (credit) side of the account, and
(3) Liability and owners’ equity accounts normally have credit (right-hand)
balances.

Any Liability Account

Or Owners’ Equity Account

Debit Credit
(representing (representing
a decrease) an increase)

Concise Statement of the Rules of Debit and Credit

The use of debits and credits to record changes in assets, liabilities, and
owners’ equity may be summarized as follows:

Asset Accounts Liability & Owners’ Equity Accounts

Normally have debit balances. Thus, Normally have credit balances. Thus
Increase are recorded by debits and Increase are recorded by credits and
Decreases are recorded by credits. Decreases are recorded by debits.

Double-Entry Accounting – The Equality of Debits and Credits

The rules for debits and credits are designed so that every transaction is
recorded by equal dollar amounts of debits and credits. The reason for this
equality lies in the relationship of the debit and credit rules to the accounting
equation:
Assets = Liabilities + Owners’ Equity

Debit balances = Credit Balances

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If this equation is to remain in balance any change in the left side of the
equation (assets) must be accompanied by an equal change in the right side
(either liabilities or owners equity). According to the debit and credit rules that
we have just described, increases in the left side of the equation (assets) are
recorded by debits, while increases in the right side (liabilities and owners
equity) are recorded by credits.
This system is often called double-entry accounting. The phrase “double-
entry” refers to the need for both debit entries and credit entries (equal in
dollar amounts) to record every transaction. Virtually every business
organization uses the double-entry system regardless of whether the company’s
accounting records are maintained manually or by computer. In addition the
double-entry system allows us to measure net income at the same time we
record the effects of transactions upon the balance sheet accounts. (the
measurement of net income is discussed in chapter 3.)
Running Balance Forms of Accounts
T accounts are widely used in the classroom and in accounting text books,
because they provide a concise conceptual picture of the financial effects of a
business transaction. In actual practice, however, most businesses prefer to
use the running balance form of ledger account. This form of account has
special columns for recording additional information, as illustrated below with
the Cash account of Greenhill.

Cash Account No. 1

Date Explanation Ref Debit Credit Balance
20 __
Oct. 1 80,000 80,000
3 52,000 28,000
5 6,000 22,000
25 600 22,600
30 6,800 15,800

The date column shows the date of the transaction – which is not necessary
the same as the date the entry recorded in the accounts. The explanation
column is needed only for unusual items, and in many companies it is seldom
used. The Ref (Reference) column is used to list the page number of the journal
in which the transaction is recorded, thus making it possible to trace ledger
entries back to their source. The use of a journal is explained later in this
chapter. In the balance column of the account, the new balance is entered
each time the account is debited or credited. Thus the current balance of the
account can always be observed at a glance.

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Sequence and numbering of Ledger Accounts
Accounts are usually arranged in the ledger in financial statement order, that
is, assets first, followed by liabilities, owners’ equity, revenue, and expenses.
The number of accounts needed by a business will depend upon its size, the
nature of operations, and the extent to which management and regulatory
bodies want detailed classification of information. An identification number is
assigned to each account. A chart of accounts is a list of the account titles
and account numbers being used by a given business.
In the following list of accounts, certain numbers have not been assigned, these
numbers are held in reserve so that additional accounts can be inserted in the
ledger in proper sequence whenever such accounts become necessary. In this
illustration, the numbers from 1 to 29 are used exclusively for asset accounts;
numbers from 30 to 49 are reserved for liabilities; and numbers in the 50s
signify owners’ equity accounts. (Revenue and expense will be discussed in
chapter 3.) The balance sheet accounts used thus far in our Greenhill Real
Estate illustration are numbered as shown in the following chart of accounts:

Chart of Accounts
Account Title Account No.
Assets:
Cash …………………………………………………………… 1
Accounts Receivable ……………………………………… 4
Land …………………………………………………………… 20
Building ……………….……………………………………... 22
Office Equipment ……….…..……………………………. 25
Liabilities:
Notes Payable ……..………………………………………… 30
Accounts Payable …………………………………………. 32

Stockholders” Equity:
Capital Stock …..…………………………………………… 50
Retained earnings ……………..…..……………………… 55

In large businesses with hundreds or thousands of accounts, a more elaborate

numbering system is used. Some companies use an eight- or ten-digit number
for each ledger account; each of the digits carries special significance as to the
classification of the account.
Sequence of Asset Accounts
As shown in the balance sheets we have illustrated, cash is listed first among
the assets. It is followed by such assets as marketable securities, short-term
notes receivable, accounts receivable, inventories, and supplies. These are the
most common examples of current assets. The term current assets includes
cash and those assets which will quickly be converted into cash or used up in

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operations. Next on the balance sheet come the relatively permanent assets
used in the business (often called plant assets.) Of the group, land is listed
first and followed by buildings. After these two items, any order is acceptable
for other assets used in the business, such as automobiles, furniture and
fixtures, computers, lighting equipment, store equipment, etc.

The Journal
In our preceding discussion, we recorded business transactions directly in the
company’s ledger account. We did this in order to stress the effects of business
transactions upon individual asset, liability, and owners’ equity accounts
appearing in the company’s balance sheet. In actual accounting system,
however, the information about each business transaction is initially recorded
in an accounting record called the journal. After the transactions have been
recorded in the journal, the debit and credit changes in the individual accounts
are entered in the ledger. Since the journal is the accounting record in which
transactions are first recorded, it is sometimes called the book of original
entry.
The journal is a chronological (day-by-day) record of business transactions. The
information recorded about each transaction includes the date of the
transaction, the debit and credit changes in specific ledger accounts, and a
brief explanation of the transaction. At convenient intervals, the debit and
credit amounts recorded in the journal are transferred (posted) to the accounts
in the ledger.

Why use a Journal?

Since it is technically possible to record transactions directly in the ledger, why
bother to maintain a journal? The answer is that the unit of organization for
the journal is the transaction, whereas the unit of organization for the ledger
is the account. By having both a journal and a ledger, we achieve several
advantages which would not be possible if transactions were recorded directly
in ledger accounts;
1. The journal shows all information about a transaction in one place
and also provides an explanation of the transaction.
2. The journal provides a chronological record of all the events in the
life of the business.
3. The use of a journal helps to prevent errors.

The General Journal: illustration of Entries

Many businesses maintain several types of journals. The nature of operations
and the volume of transactions in the particular business determine the
number and type of journals needed. The simplest type of a journal is called a
general journal, and is shows on the next page. A general journal has only two
money columns, one for debits and the other for credits; it may be used for all
types of transactions.

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 GENERAL JOURNAL Page No. 1
Date Account Title and Explanation LP Debit Credit
20 __
Oct. 1 Cash 1 80,000
Capital Stock 50 80,000
Issued 8,000 shares of stock for cash.

3 Land 20 52,000
Cash 1 52,000
Purchased land for office site.

5 Building 22 36,000
Cash 1 6,000
Notes Payable 30 30,000
Purchase building to be moved to our lot.
Paid part cash, balance payable within 90 days.

17 Office Equipment 25 13,800

Accounts Payable 32 13,800
Purchased equipment on credit from Business
Warehouse.

20 Accounts Receivable 4 1,800

Office Equipment 25 1,800
Sold unused office equipment at cost to
Village Animal Hospital, due within 30 days.

25 Cash 1 600
Accounts Receivable 4 600
Collect part of receivable from Village Animal
Hospital.

30 Accounts Payable 32 6,800

Cash 1 6,800
Made partial payment of the liability to Business
Warehouse.

The process of recording a transaction in a journal is called journalizing the

transaction. To illustrate the use of the general journal, we shall now journalize
the October transactions of Greenhill Real Estate.
Efficient use of a journal requires two things: (1) ability to analyze the effects
of a transaction upon assets, liabilities, and owners’ equity and (2) familiarity
with the standard form and arrangement of journal entries.

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Posting
The process of transferring the debits and credits from the journal to the
proper ledger accounts is called posting. Each amount listed in the debit
column of the journal is posted by entering it on the debit side of an account in
the ledger, and each amount listed in the credit column of the journal is posted
to the credit side of a ledger account.
The mechanics of posting may vary somewhat with the preferences of the
individual.
The following sequence is commonly used.
1. Locate in the ledger the first account named in the journal entry.
2. Enter in the debit column of the ledger account the amount of the debit
as shown in the journal.
3. Enter the date of the transaction in the ledger account.
4. Enter in the reference column of the ledger account the number of the
journal page from which the entry is being posted.
5. The recording of the debit in the ledger account is now complete; as
evidence of this fact, return to the journal and enter in the LP (ledger
page) column the number of the ledger account or page to which the
debit was posted.
6. Repeat the posting process described in the preceding five steps for the
credit side of the journal

Entering the journal page number in the ledger account and listing the ledger
account number in the journal provide a cross-reference between these two
records.

Ledger Accounts after Posting

After all the October transactions have been posted, Greenhill’s ledger appears
as shown below. The accounts are arranged in the ledger in the same order as
in the balance sheet – that is, assets first, followed by liabilities and owners’
equity.
To conserve space in this illustration, several ledger accounts appear on a
single page. In actual practice, however, each account occupies a separate
page in the ledger.

Cash Account No. 1

Date Explanation Ref Debit Credit Balance
20 __
Oct. 1 1 80,000 80,000
3 1 52,000 28,000
5 1 6,000 22,000
25 1 600 22,600
30 1 6,800 15,800

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 Accounts Receivable Account No. 4
Date Explanation Ref Debit Credit Balance
20 __
Oct. 20 1 1,800 1,800
25 1 600 1,200

Land Account No. 20

Date Explanation Ref Debit Credit Balance
20 __
Oct. 3 1 52,000 52,000

Building Account No. 22

Date Explanation Ref Debit Credit Balance
20 __
Oct. 5 1 36,000 36,000

Office Equipment Account No. 25

Date Explanation Ref Debit Credit Balance
20 __
Oct. 17 1 13,800 13,800
20 1 1,800 12,000

Notes Payable Account No. 30

Date Explanation Ref Debit Credit Balance
20 __
Oct. 5 1 30,000 30,000

Accounts Payable Account No. 32

Date Explanation Ref Debit Credit Balance
20 __
Oct. 17 1 13,800 13,800
30 1 6,800 7,000

Capital Stock Account No. 50

Date Explanation Ref Debit Credit Balance
20 __
Oct. 1 1 80,000 80,000

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The Trial Balance
Since equal dollar amounts of debits and credits are entered in the accounts
for every transaction recorded, the sum of all the debits in the ledger must be
equal to the sum of all the credits. If the computation of account balances has
been accurate, it follows that the total of the accounts with debit balances
must be equal to the total of the accounts with credit balances.

Before using the account balances to prepare a balance sheet, it is desirable to

prove that the total of accounts with debit balances is in fact equal to the total
of accounts with credit balances. This proof of the equality of debit and credit
balances is called a trial balance.
The trial balance is a two column schedule listing the names and balances of
all the accounts in the order in which they appear in the ledger; the debit
balances are listed in the left-hand column and the credit balances in the right-
hand column. The totals of the two columns must agree. A trial balance taken
from Greenhill’s ledger follows:

GREENHILL REAL ESTATE

Trial Balance
October 31, 20___

Cash ……………………………………… $15,800

Accounts Receivable ………………. 1,200
Land …………………………………….. 52,000
Building ……………….………………. 36,000
Office Equipment ……….…..……… 12,000
Notes Payable …………………………. $ 30,000
Accounts Payable …………………… 7,000
Capital Stock …..……………………. 80,000
$117,000 $117,000

Uses and Limitations of the Trial Balance

The trial balance provides proof that the ledger is in balance. The agreement of
the debit and credit totals of the trial balance gives assurance that:
1. Equal debits and credits have been recorded for all transactions.
2. The debit or credit balance of each account has been correctly computed.
3. The addition of the account balances in the trial balance has been
correctly performed.
Suppose that the debit and credit totals of the trial balance do not agree. This
situation indicates that one or more errors have been made. Typical of such
errors are (1) the posting of a debit as credit, or vice versa; (2) arithmetic
mistakes in balancing accounts; (3) clerical errors in copying account balances
into the trial balance; (4) listing a debit balance in the credit column of the trial
balance, or vice versa; and (5) errors in addition of the trial balance.

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The preparation of a trial balance does not prove that transactions have been
correctly analyzed and recorded in the proper accounts. If, for example, a
receipt of cash were erroneously recorded by debiting the Land account instead
of the Cash account, the trial balance would still balance. Also, if a transaction
were completely omitted from the ledger, the error would not be disclosed by
the trial balance. In brief, the trial balance proves only one aspect of the
ledger, and that is the equality of debits and credits.

Despite these limitations, the trial balance is useful device. It not only provides
assurance that the ledger is in balance, but it also serves as a convenient
stepping-stone for the preparation of financial statements.

As explained in chapter one, the balance sheet is a formal statement showing

the financial position of the business, intended for distribution to managers,
owners, bankers, and various outsiders. The trial balance, on the other hand,
is merely a working paper, useful to the accountant but not intended for
distribution to others. The balance sheet and other statements can be
prepared more conveniently from the trial balance than directly from the
ledger, especially if there are a great many ledger accounts.

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