External events involve an exchange transaction between the company and a separate economic entity. For every external transaction, the company is receiving something in exchange for something else. Internal events do not involve an exchange transaction but do affect the financial position of the company. Examples of external events are the purchase of inventory, a sale to a customer, and the borrowing of cash from a bank. Examples of internal events include the recording of depreciation expense, the expiration of prepaid rent, and the accrual of salary expense.
According to the accounting equation, there is equality between the total economic resources of an entity, its assets, and the claims to those resources, liabilities and equity. This implies that, since resources must always equal claims, the net effect of any transaction cannot affect one side of the accounting equation differently than the other side.
The purpose of a journal is to capture, in chronological order, the dual effect of a transaction. A general ledger is a collection of storage areas called accounts. These accounts keep track of the increases and decreases in each element of financial position.
Permanent accounts represent the financial position of a company - assets, liabilities and owners' equity - at a particular point in time. Temporary accounts represent the changes in shareholders’ equity, the retained earnings component of equity for a corporation, caused by revenue, expense, gain, and loss transactions. It would be cumbersome to record revenue/expense, gain/loss transactions directly into the permanent retained earnings account. Recording these transactions in temporary accounts facilitates the preparation of the financial statements.
Assets are increased by debits and decreased by credits. Liabilities and equity accounts are increased by credits and decreased by debits.
Revenues and gains are increased by credits and decreased by debits. Expenses and losses are increased by debits (thus causing owners’ equity to decrease) and decreased by credits (thus causing owners’ equity to increase).
Answers to Questions (continued)
The first step in the processing cycle is to identify external transactions affecting the accounting equation. Source documents, such as sales invoices, bills from suppliers and cash register tapes, help to identify the transactions and then provide the information necessary to process the transaction.
Transaction analysis is the process of reviewing the source documents to determine the dual effect on the accounting equation and the specific elements involved.
After transactions are recorded in a journal, the debits and credits must be transferred to the appropriate general ledger accounts. This transfer is called posting.
Transaction 1 records the purchase of $20,000 of inventory on account. Transaction 2 records a credit sale of $30,000 and the corresponding cost of goods sold of $18,000.
An unadjusted trial balance is a list of the general ledger accounts and their balances at a time before any end-of-period adjusting entries have been recorded. An adjusted trial balance is prepared after adjusting entries have been recorded and posted to the accounts.
Answers to Questions (continued)
Adjusting entries record the effect on financial position of internal events, those that do not involve an exchange transaction with another entity. They must be recorded at the end of any period when financial statements are prepared to properly reflect financial position and results of operations according to the accrual accounting model.
Closing entries transfer the balances in the temporary owners’ equity accounts to a permanent owners’ equity account, retained earnings for a corporation. This is done only at the end of a fiscal year in order to reduce the temporary accounts to zero before beginning the next reporting year.
Prepaid expensesrepresent assets recorded when a cash disbursement creates benefits beyond the current reporting period. Examples are supplies on hand at the end of a period, prepaid rent, and the cost of plant and equipment.
The adjusting entry required when unearned revenues are earned is a debit to the unearned revenue liability and a credit to revenue.
Accrued liabilities are recorded when an expense has been incurred that will not be paid until a subsequent reporting period. The adjusting entry required to record an accrued liability is a debit to anexpenseand a credit to a liability.
Answers to Questions (continued)
Income statement - The purpose of the income statement is to summarize the operating activities of the company during a particular period of time. It is a change statement that is reporting the changes in owners’ equity that occurred during the period as a result of operating transactions (revenues, expenses, gains and losses).
Balance sheet - The purpose of the balance sheet is to present the financial position of the company at a particular point in time. It is an organized array of assets, liabilities, and permanent owners’ equity accounts.
Statement of cash flows - The purpose of the statement of cash flows is to disclose the events that caused cash to change during the period.
Statement of shareholders’ equity - The purpose of the statement of shareholders’ equity is to disclose the sources of the changes in the various permanent shareholders’ equity accounts that occurred during the period.
A worksheet provides a means of organizing the accounting information needed to prepare adjusting and closing entries and the financial statements. This error would result in an overstatement of revenue and thus net income and retained earnings, and an understatement of liabilities.
Reversing entries are recorded at the beginning of a reporting period. They remove the effects of some of the adjusting entries made at the end of the previous reporting period. This simplifies the journal entries made during the new period by allowing cash payments or cash receipts to be entered directly into the expense or revenue account without regard to the accrual made at the end of the previous period.
The purpose of special journals is to record, in chronological order, the dual effect of repetitive types of transactions, such as cash receipts, cash disbursements, credit sales and credit purchases.
Special journals simplify the recording process in the following ways: (1) journalizing the effects of a particular transaction is made more efficient through the use of specifically designed formats, (2) individual transactions are not posted to the general ledger accounts, but are accumulated in the special journals and a summary posting is made on a periodic basis, and (3) the responsibility for recording journal entries for the repetitive types of transactions is placed on individuals who have specialized training in handling them.
Answers to Questions (concluded)
The general ledger is a collection of control accounts representing assets, liabilities, permanent and temporary shareholders’ equity accounts. The subsidiary ledger contains a group of subsidiary accounts associated with a particular general ledger control account. For example, there will be a subsidiary ledger for accounts receivable that will keep track of the increases and decreases in the account receivable balance for each of the company’s customers purchasing goods or services on credit. At any point in time, the balance in the accounts receivable control account should equal the sum of the balances in the accounts receivable subsidiary ledger accounts.
Assets = Liabilities + Paid-in Capital + Retained Earnings