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Module 2: Recording transactions

Overview
Accounting can be viewed as an information system that consists of inputs, processing, and outputs. In Module 1 you studied
the accounting outputs
the major financial statements. This module explains how the transactions are
recorded in accounts the inputs
. Inputs in the form of transaction documents such as invoices and
cheques are processed through a series of steps called the accounting cycle. This module introduces you to the first four
steps of the accounting cycle, while Module 3 completes the steps. The accounting cycle must function properly if financial
statements are to fairly present the economic results of an organizations activities.
. Therefore, in order to master the concepts, it is strongly
Accounting procedures are best learned by doing
recommended that you thoroughly work through the exercises presented in the text and these module notes, and make use
of the resources available at the online Student Success Centre.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study
required.

Learning objectives
2.1

Explain the transactions recorded in accounting systems and the importance of source documents in
these systems. (Level 1)

2.2

Record the effects of transactions in accounts, and explain the chart of accounts and ledger. (Level
1)

2.3

Analyze transactions using debits and credits, and record their effects in accounts. (Level 1)

2.4

Record transactions in a general journal, and post entries from the journal to the ledger using the
balance column format. (Level 1)

2.5

Prepare a trial balance and explain its usefulness. (Level 1)

Module summary

Print this module

Assignment reminder: Assignment 1 (see Module 5) is due at the end of week 5 (see Course Schedule).
You may wish to take a look at it now in order to familiarize yourself with the requirements and to prepare
for any necessary work in advance.

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Module 2 Test your knowledge

1. Which of the following entries will not

1.
2.
3.
4.

Debit
Debit
Debit
Debit

to
to
to
to

affect owners equity?

inventory and credit to cash

insurance expense and credit to insurance payable
withdrawal and credit to cash
cash and credit to interest earned

2. In reviewing the accounts of Strand Co., you discovered that a credit of $1,000 to prepaid insurance was wrongly
credited to accounts receivable, and an $800 prepayment that was remitted for a radio advertisement was not
posted. Which of the following statements reflect the effect of the errors?
1.
2.
3.
4.

There is no change in the total assets and the owners equity.

Total assets is understated by $200 and owners equity is understated by $200.
Total assets is overstated by $1,000 and owners equity is overstated by $1,000.
Total assets is overstated by $800 and owners equity is overstated by $800.

3. Gable Corporation observed the following error in its financial statements. An amount of $30,000, received from a
customer as a deposit for an item with a sales value of $80,000, was credited to sales. The goods are expected to be
delivered after the year end. What is the effect of this error?
1.
2.
3.
4.

Liabilities
Liabilities
Liabilities
Liabilities

understated, net income understated, and owners equity understated by $30,000

overstated, net income overstated, and owners equity overstated by $50,000
understated, net income understated, and owners equity understated by $50,000
understated, net income overstated, and owners equity overstated by $30,000

4. Jean Pool observed the following error: An amount of $3,500 paid to a supplier in payment of an accounts payable
was wrongly debited to Office expenses. What is the effect of this error?
1.
2.
3.
4.

Liabilities are overstated by $3,500 and owners equity is understated by $3,500.

Assets are understated by $3,500 and liabilities are understated by $3,500.
Liabilities are overstated by $7,000 and owners equity is understated by $7,000.
Liabilities are understated by $7,000 and owners equity is understated by $7,000.

5. Tivoli Ltd. uses the gross method to record sales, and provides terms of 2/10, n/30. On January 9, 2011, the
company made a $50,000 credit sale to Earshot Ltd. On January 17, Earshot made a payment on the January 9 sale
that resulted in a $25,000 reduction to a Tivoli accounts receivable account. What would be the effect on net income
of the January transactions with Earshot?
1.
2.
3.
4.

An
An
An
An

increase
increase
increase
increase

in
in
in
in

net
net
net
net

income
income
income
income

of
of
of
of

$25,000
$49,000
$49,500
$50,500

Solutions

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2.1 Economic events and source documents

Learning objective

Explain the transactions recorded in accounting systems and the importance of source documents in these systems. (Level 1)

Required reading

Chapter 3, pages 74-75

LEVEL 1

Accounting is a multi-step process known as the accounting cycle and broadly covers
1. Analyzing economic activities and recording their effects;
2. Classifying and summarizing the recorded effects in financial statements; and
3. Capturing data to provide useful information in the form of financial statements and other reports to economic
decision makers.
This multi-step accounting process is summarized in a flowchart in Exhibit 3.1 on page 75. The flowchart shows the process
in which financial statements are prepared from economic activities. Economic activities include both external and internal
transactions:

An external transaction is a completed economic exchange between an organization and one or more outside
parties.
An internal transaction is an economic activity that has an effect on the accounting equation, but does not involve
an outside party.

Not all activities that have an effect on the organization are recorded as transactions, for instance, changes in market interest
rates (assuming that the firms financial assets and financial liabilities have been designated as being held to maturity).
to be recorded as a
The effect of an activity must be reliably measured
transaction. A measure is reliable if the dollar amount of the activity is reasonably free from error, unbiased, and is a faithful
representation of the activity. Users of financial statements expect accounting information to be reliable so that they can
depend on it to make decisions.
Source documents, also known as business papers, provide evidence of transactions and are the basis for recording them.
Examples of source documents include cheques, sales slips or invoices, bank statements, purchase orders, customer billings,
employee earnings records, and cash register tapes (see EYK 2-5).
evidence of transactions rather than subjective estimates.
Source documents provide verifiable
Data from economic events should result in similar recognition and accounting treatment if used by two different qualified
persons.

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2.2 Accounts
Learning objective

Record the effects of transactions in accounts, and explain the chart of accounts and ledger. (Level 1)

Required reading

Chapter 3, pages 76-82

LEVEL 1

Accounts provide the economic foundation on which the accounting system is built. Exhibit 3.2 on page 76 lists examples of accounts
you have studied. These accounts were used to summarize financial transactions. The balances of these accounts flow into financial
statements the income statement, the statement of owners equity, the balance sheet, and perhaps the statement of
comprehensive income. Source documents provide much of the evidence of the accounting information that flows into the accounts
from external events. For many internal transactions, the linkage between source documents and the recording of
economic activities is not clearly defined. In such cases, the accountant must make assumptions and use judgement (to determine
the amount of the internal transaction), which may require changes to be made to the balances in some of the accounts at the end
of each accounting period.

Types of accounts
Accounts are basic records that are used to document changes both increases and decreases in assets, liabilities, and
owners equity. A separate account is kept for each financial statement element. This enables accountants to effectively and
accurately maintain accounting records. The sum of all the transactions in an account at any specific time is known as the
account balance. This balance changes as the accounts are debited
and credited.
When deciding what type of account is affected by a transaction and whether a debit or credit is required, it is helpful to group
accounts into six categories assets, liabilities, owners capital, revenues, expenses, and owners withdrawals as shown in Exhibit
3.8 on page 81. The following paragraphs describe these accounts.
Asset accounts

Asset accounts are permanent accounts. This means that they carry their balances forward from one period to the next.
Examples of asset accounts include Cash (on hand and in the bank), Receivables, Prepaid expenses (insurance, rent, taxes,
office supplies), Equipment, Buildings, and Land. Study the description of these accounts on pages 76-77.
Liability accounts

Liability accounts are also permanent accounts. Examples of liability accounts are Payables, Unearned revenues
(subscriptions, gift certificates, airline tickets, rent), and Other liabilities (wages payable, taxes payable, interest payable).
These are explained on page 77.
,
According to the revenue recognition principle
revenue is recorded when earned. If cash is received before it is actually earned, this increase in assets is matched by an
increase in liabilities (unearned revenue). Later, when the earnings process is complete, the liability (unearned revenue) is
replaced by an increase in owners equity (revenue). Unearned revenue is often referred to as deposits or deferred
revenue. Note the advance ticket sales in the WestJet example near the middle of page 77.
Companies that provide warranties on their products must report a liability based on the estimated amount that they will
spend in the future fulfilling their obligation under the term of the warranty. This is an application of the
matching principle
, which states that expenses should be recorded in the same
accounting period as the revenue that relates to these expenses.
Owners equity accounts

A number of items affect owners equity. The net balance of owners equity is carried forward to the next accounting period through

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the capital account. Separate accounts are used for each item affecting owners equity, such as investments by the owner,
withdrawals by the owner, revenues and expenses. Each of these accounts is discussed below.
Capital account

For a proprietorship, a capital account is used to record the original investment and any permanent additional increases or
decreases in owners equity.
Withdrawals account

A withdrawals account (also known as a personal account or drawing account) is not

a salary or an expense of the
business. The owners withdrawals of earnings or anticipated earnings include withdrawals of cash (or other assets) for
personal use. Withdrawals are a distribution of earnings, rather than an expense. Withdrawals
are not recorded in the income
statement
. You may think of withdrawals as the opposite of an investment by the owner, or as a
disinvestment.
Revenue and expense accounts

Examples of revenue accounts include revenues from repairs, commissions earned, legal fees earned, rent earned, and
interest earned. Examples of expense accounts include advertising expense, office supplies expense, salaries expense, rent
expense, utilities expense, and insurance expense.

Textbook activities

Checkpoint Questions 1 to 3 on page 78

(Solutions on page 97)
Quick Study 3-1 on page 105

(Solution)

LEVEL 2

T-accounts
The text explains the usefulness of T-accounts on page 78. T-accounts are usually an easy way of keeping track of account balances
when completing assignment and examination questions.
LEVEL 1

The accounting equation

The accounting equation is expressed as
Assets = Liabilities + Owners equity
Note in Exhibit 3.7 on page 80 that regardless of the type of account, debits are always on the left side of the T-account while
credits are on the right side.
Many beginning accounting students find the terms debit and credit confusing. This is not surprising given the many meanings
attached to these expressions in everyday life, not the least of which are credit cards and debit cards.
The underlying principles of debits and credits and how they increase or decrease accounts (as shown in Exhibit 3.7 on page 80) is
based on mathematical principles. To demonstrate, lets look at a simple example. Assume that there are assets of $10 and $6 in
equity. This can be described in the following linear equation:
Assets
10

=
=

Liabilities
X

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+

Equity
6

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Can you solve for X? Of course! X = 4. But how did you get that answer? Reviewing the mathematical steps in detail will help you
understand the underlying nature of debits and credits.
To solve this linear equation with one unknown variable, you need to get X (representing liabilities) all alone on the right side of the
equation. To do this, subtract 6 from both sides of the equation. In effect, by taking the 6 to the left side of the equation, it changes
from a + to a as follows:
Assets
10
10 6
4

=
=
=
=

Liabilities
X
X
X

+
+
+

Equity
6
66

Moving a positive number to the other side of the equation makes it negative and moving a negative number to the other side of the
equation makes it positive. Debits and credits work on the same mathematical principle, as follows:

Further, this is why, as detailed in Exhibit 3.8 on page 81, assets normally have debit balances, while liabilities and owners equity
accounts normally have credit balances. As such, the equation
Assets = Liabilities + Owners equity can be restated as
Debits = Credits.
Double-entry accounting means every transaction affects and is recorded in at least two accounts (see page 80). The process
requires that the sum of the debits must equal the sum of the credits. A fundamental axiom of accounting is therefore Assets =
Liabilities + Equity, which leads to Debits = Credits.
The rules for owners equity require a review of the four types of transactions affecting owners equity and the four related accounts.
Owners equity is represented by the owners capital account. There are four transactions that cause equity or capital to change:
investments by the owner, withdrawals by the owner, revenues, and expenses.
1. Investments by the owner cause an increase in equity. Increases in equity are always recorded as credits. Therefore,
investments by the owner are credited to capital.
2. Withdrawals by the owner cause a decrease in equity. Decreases in equity are always recorded as debits. Therefore, you
would think that withdrawals by the owner should be debited to equity or the capital account. However, in order to track
owner withdrawals separately from owner investments, you create a separate account for withdrawals. Withdrawals by the
owner should be debited to withdrawals, a type of equity account.
3. Revenues increase owners equity. Increases in equity are always recorded as credits. Again, you would think that revenues
should be credited to the capital account. However, in order to track revenues separately from other equity transactions, you
credit a revenue account. Remember that revenues are one of four types of equity transactions as summarized in the
owners equity T-account below.
4. Expenses decrease owners equity. Decreases in equity are always recorded as debits. You could debit expenses to capital,
but in order to track expenses separately from other types of equity transactions, you debit an expense account.
To summarize:

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This relationship is also shown in Exhibit 3.8 on page 81.

The recording of revenues and expenses affects owners equity. For example, an increase in an expense is the same as a decrease in
owners equity. Since a decrease in owners equity is recorded as a debit, an increase in an expense account should also be recorded
as a debit.

Normal balances
The normal balance of each type of account is either a debit balance or a credit balance, depending on which side of the account
is used to record increases. Since assets increase with debits, the normal balance for assets is a debit. Since liabilities and owners
equity accounts increase with credits, the normal balance for these accounts is a credit. See Example 2-1 for an illustration.

The income statement and the accounting equation

The income statement is simply an extension of the balance sheet. Revenue accounts such as Fees earned increase owners equity.
Expenses decrease owners equity. You may ask why an income statement is needed at all, since you could simply enter changes in
revenue and expense directly into owners equity. This, however, would make it difficult to determine the profitability of the entity
over a period of time. This type of information is important to both internal and external users of accounting information. The use of
revenue and expense accounts provides details needed for decision-making.
Refer to the financial statements shown on pages 28 and 48 to reinforce the relationship between the income statement and the
balance sheet. (Note that the income statement on page 28 shows a net income, while page 48 shows an example of a net loss.)
Notice how the income statement flows to the statement of owners equity and then flows to the balance sheet. This order must be
maintained for the financial statements to properly reflect the economic activities of the period.

Chart of accounts and ledgers

A chart of accounts is a list of all accounts used by a company. Each account is identified by a name and a code number. Account
is unclear. It could be an asset (Prepaid rent), a liability
names should be descriptive and clear. For example, rent
(Unearned rent), a revenue (Rent earned), or an expense account (Rent expense). Account numbers are assigned according to a preestablished system. Refer to page 82 and Appendix II at the back of the text for examples of a chart of accounts. These examples
are for a small business using a three-digit account numbering system. More complex businesses use four, five, or more digits as
account numbers. The account number can also identify whether an account appears on the balance sheet or the income statement.
The purpose of a chart of accounts is to help you set up the general ledger. The term ledger refers to a collection of all the
companys accounts. The preparation of the balance sheet and the income statement is facilitated by referring to the financial
information contained in the general ledger.

Textbook activities

Checkpoint Questions 4 and 5 on page

82 (Solutions on page 97)
Quick Study 3-2 to 3-6 on pages 105-106
Mid-Chapter Demonstration Problem
on page 83

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2.3 Analyzing transactions

Learning objective

Analyze transactions using debits and credits, and record their effects in accounts. (Level 1)

Required reading

Chapter 3, pages 83-88

LEVEL 1

At this point, it is useful to preview the steps of the accounting cycle. The various steps have been arbitrarily divided into
three stages:
1. Steps occurring throughout the year
2. Steps occurring at the end of the year
3. Steps occurring at the beginning of the next year
The accounting cycle is presented in a flowchart in Exhibit 2-1. An abbreviated version of this flowchart is shown in Exhibit
3.1 on page 75.
Transaction analysis is the first step in the accounting cycle. You need to perform this step before you can record a firms
economic activities. To analyze transactions, follow this procedure:
1. Determine the types of accounts affected (asset, liability, owners capital, revenue, expense, owners withdrawals).
2. Determine the account balances that will increase and/or decrease as a result of the transaction.
3. Express the increase and/or decrease using the terms "debit" and "credit."
The terms debit
and decrease

and credit
must not be confused with increase
. In accounting, debit simply means left side and credit means right side.

You have already studied the impact on the accounting equation of the financial transactions for Finlay Interiors (pages 3439). These transactions and four additional transactions are now analyzed to determine the debit and credit effect on the
accounts.
Analyzing financial transactions involves identifying which accounts have been affected and by how much. Double-entry
accounting requires that these changes be labelled as debits and credits. For example, the investment of $10,000 by Carol
Finlay into her business is a financial transaction that caused two accounts to change:

Cash increased by $10,000 (cash is an asset and increases in assets are shown as a debit)
Carol Finlay, Capital increased by $10,000 (equity increases as a result of owner investments, and increases in equity
are recorded as a credit)

The effect on Cash and Carol Finlay, Capital, is illustrated using T-accounts in transaction (1) on page 83. Notice that the
total debits of $10,000 equal total credits of $10,000.
$10,000 in the business,"
You may have difficulty with transactions such as "Carol Finlay invested
thinking that the investment should be an asset of some sort. Terminology can be confusing. It is therefore important that
you look closely at the substance
of the transaction and clearly identify from whose perspective you
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are preparing the journal entry.

In this case, you have to recognize that you are recording the transaction from the viewpoint of Finlay Interiors, not Carol
Finlay. Therefore, the fact that Carol Finlay is making an investment is irrelevant to you.
What is important to Finlay Interiors is that it received $10,000 in cash. It thus debits (increases) its cash asset by this
amount. The cash did not come without strings attached, however. Indeed, in return for the cash, Carol Finlay now has an
increased claim against the assets of the business. That is, the owner's equity in the business has increased. Finlay Interiors
records this fact by crediting (increasing) Carol Finlays Capital account.
When Finlay Interiors buys supplies for $2,500 cash, what accounts are affected? Supplies, an asset, is increased, and
increases in assets are recorded as a debit. Cash is also affected by this transaction. Cash, also an asset, is decreased.
Decreases in assets are recorded as a credit. You can see how this transaction is recorded in T-accounts in transaction (2) on
page 84.
Go through the remaining transactions (3) through (15) on pages 84-86 of the text. Review each transaction closely. Observe
what accounts are affected and identify how the changes in each account are recorded as debits and credits. Note how the
debits equal credits in every transaction. Read the "Analysis" given for each transaction carefully.
In transaction (9) on page 85, cash is collected from the credit customer of transaction (8). A common error is to credit a
revenue account in transaction (9). If revenue is credited in both transaction (8) and transaction (9), revenue will be doublecounted, and this is incorrect. Remember that the revenue recognition
principle
requires that revenue be recorded when earned, irrespective of whether the cash has been
collected or not.
Now review Exhibit 3.9 on page 87 and observe how each account balance was calculated. See how the equation A = L + E
continues to hold.

Textbook activities

Checkpoint Questions 6 to 9 on
page 88
(Solutions on page 97)
Quick Study 3-7 on page 106

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2.4 Journalizing and posting transactions

Learning objective

Record transactions in a general journal, and post entries from the journal to the ledger using the balance column format.
(Level 1)

Required reading

Chapter 3, pages 88-93

LEVEL 1

Journalizing transactions
The first step in the accounting cycle is analyzing transactions. The next formal step in the processing of financial statements
is recording the transactions in a journal, or journalizing. This topic explains the established practice of journalizing and
posting transactions.
A journal entry can be seen as an instruction to change the balance of accounts. All transactions involve at least two
accounts. When more than two accounts are affected, it is called a compound journal entry. See the compound entry on
January 1 in Exhibit 3.11 on page 89, in which Supplies ($1,100) and Furniture ($6,000) are purchased on credit.
General journal

The general journal (or journal) is a book of original entry that links the debits and credits of individual transactions by
providing a complete record of each transaction in one place, in chronological order. The debits and credits are copied from
the journal to the book of final entry (the general ledger or ledger). This procedure is especially helpful in tracing debits
and credits to accounts when an error is discovered.

Textbook activity

Problem 3-3B on page 121.

The point of this question is to give you
some practice journalizing transactions. This also serves to reinforce your ability to analyze transactions.
Solution
The most common error in this question is to record the September 28 transaction as wage expense. Remember that
distributions of capital to the owner of a sole proprietorship are recorded as a withdrawal of equity.

Posting transactions
Posting is the process of copying journal entry information from the journal to the ledger. Exhibit 3.12 on page 90 is a
standard ledger account form used for posting, in the balance column format. Exhibit 3.13 on page 92 illustrates the six
steps used to post a journal entry to a ledger.

Note:
1. When posting into the general ledger accounts, the explanation column should also be completed. For example, in
Exhibit 3.12 on page 90 of the textbook (copied below), the explanation column for the first January 1 entry should
include "Investment by owner" since the $10,000 was the result of the owner investing cash into the business. The
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explanation column for the second January 1 entry should specify "Purchased store supplies for cash," and the
explanation for January 10 should state Performed services for cash.

2. A general journal page and a balance column format ledger page are included. You may find these forms useful for
completing questions in this and subsequent modules. Because transactions affecting cash are generally more
frequent, you should use the first, larger General Ledger account for Cash.

Computerized accounting
In the modern business world, financial and other company information is almost always captured by electronic systems.
Many computerized accounting packages are widely available for inputting, processing, and generating financial reports. In a
simple computerized system, a data-entry clerk may enter data from a paper record such as a sales invoice or purchase
order. In more sophisticated systems, a computer may accept input data from a scanning device such as that used in a
supermarket. The scanner reads a bar code that is printed or tagged on the item. The bar code identifies the item, and
stored information in the firms computer is automatically updated.
Computer systems can be designed to sort data and generate various reports and financial statements. You will learn about
computerized accounting and information systems as you progress through the CGA program of professional studies. For
is a computerized accounting system that is used in
example, Sage Accpac ERP
Financial Accounting: Assets [FA2]
to
illustrate the procedures required to prepare a companys financial statements. Sage Accpac
ERP
records financial information in a database. The database can contain information such as the account number,
account name, budget figures, and account balances. A balance can be kept each month for each account so that financial
statements can be produced for each month. Account balances from previous years can also be stored.
An important advantage of a computerized accounting system is the design feature that keeps the general ledger
continuously in balance by allowing transactions to be entered or posted only if they are balanced. A manual accounting
system offers no comparable safeguard.
The primary advantage of a computerized system is that you only need to record the transaction once in your book of
accounts. Specifically, you journalize it in an electronic fashion. The duplicative steps evident in the manual system
posting, preparing trial balances, preparing financial statements, and so on are done automatically for you with all reports
freely available at the touch of a button.
The drawback of computerized systems is that you might be lulled into a false sense of security as to the level of knowledge
needed to properly operate them. It is important for you to fully understand all steps in the accounting cycle. Otherwise,
when you make input errors, you will be unlikely to detect and correct them.

Textbook activities

Checkpoint Questions 10 to 12 on
page 93
(Solutions on page 97)
Quick Study 3-8 to 3-10 on page 107

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2.5 Preparing a trial balance

Learning objective

Prepare a trial balance and explain its usefulness. (Level 1)

Required reading

Chapter 3, pages 93-96

Appendix 4A, page 156
LEVEL 1

Accountants usually complete the posting of journal entries to the ledger accounts at the end of each month if they are using
a manual system. With a computerized system, posting is done automatically as each journal entry is recorded. To verify the
accuracy of the recording process, accountants prepare a trial balance of the ledger accounts. A trial balance not only
provides a check on the equality of debits and credits but is also a useful summary of account balances for preparing financial
statements.

Locating and correcting errors

A trial balance that does not balance may indicate the following types of errors:

Omissions in posting individual debits and credits to ledger accounts

Errors in recording entries in an account on the opposite side to which it should be
Arithmetic errors in calculating account balances
Transposition of the numbers on one side of a transaction

If the trial balance is in balance (that is, debits equal credits), this is a preliminary indication of recording accuracy. Errors
may still have been made, however, because a trial balance cannot detect mistakes such as posting an entry twice, posting
amounts to the wrong accounts, or failure to post an entry.
The steps to follow when a trial balance does not balance are clearly outlined in the text on pages 95-96.
Example 2-2 illustrates the effects of errors on the trial balance. The example corrects the trial balance for incorrect data,
omitted transactions, and transposition errors.

Formatting conventions
The text sets out various formatting conventions on page 96. You may also wish to refer to the CGA
Model Financial Statements (MFS)
the Study Resources area) for more advanced guidance.

Textbook activities

Checkpoint Questions 13 and 14 on

page 96
(Solutions on page 98)
Quick Study 3-11 to 3-14 on pages 107108
(Solutions)
Demonstration Problem on pages 98103

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Module 2 summary
Recording transactions
Explain the transactions recorded in accounting systems and the importance of source
documents in these systems.

Accounting is a multi-step process known as the accounting cycle and broadly covers

Analyzing economic activities and recording their effects

Classifying and summarizing the recorded effects in financial statements

Capturing data to provide useful information in the form of financial statements and other reports to
economic decision makers
Source documents

Business transactions affecting the accounting equation result from both external and internal activities.

The need for verifiability requires that transactions are supported by source documents.

Source documents are also called business papers.

Record the effects of transactions in accounts, and explain the chart of accounts and
ledger.

Financial statements communicate accounting information to external users.

Generally accepted accounting principles are the guidelines used in the analysis, recording, and reporting of financial
transactions on the financial statements.
The financial statements are based on the accounting equation: A = L + E.
Each account is assigned a unique number in the companys chart of accounts.
Commonly used asset accounts include

Cash

Accounts receivable

Equipment

Buildings

Land
Commonly used liability accounts include:

Accounts payable

Notes payable

Salaries or Wages payable

Commonly used equity accounts include

Owners capital

Owners withdrawals

Revenues

Expenses

Accounting cycle

The steps in the accounting cycle are followed in each accounting period to accomplish the analysis, recording, and reporting
of financial transactions. These steps are set out in the following summary points.

Analyze transactions using debits and credits, and record their effects in accounts.
Step 1: Analyzing transactions

Analyzing transactions is the first step in the accounting cycle.

To analyze transactions:
1. Determine the types of accounts affected (asset, liability, owners capital, revenue, expense, owners withdrawals),
2. Determine the account balances that will increase and/or decrease as a result of the transaction, and
3. Express the increase and/or decrease using the terminology "debit" and "credit."

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Record transactions in a general journal, and post entries from the journal to the ledger
using the balance column format.
Step 2: Recording transactions

The second step in the accounting cycle is to record debits and credits in the general journal, the book of original
entry. This process is known as journalizing.
Recording transactions is based on double-entry accounting, which requires that debits = credits.

Debits are used to record increases in assets, withdrawals, and expenses. Decreases in liabilities, the owners
capital account, and revenues are recorded with debits.

Credits are used to record decreases in assets, withdrawals, and expenses. Increases in liabilities, the owners
capital account, and revenues are recorded with credits.

Assets, expenses, and withdrawals normally have debit balances. Liabilities, owners capital, and revenue
normally have credit balances.

Step 3: Posting

The third step in the accounting cycle begins the summarization process.
Journal entries in the general journal are posted into the general ledger at the end of the accounting period.

Prepare a trial balance and explain its usefulness.

Step 4: Preparing a trial balance

The fourth step in the accounting cycle is the preparation of a trial balance that proves the equality of debits and credits.

The trial balance is prepared for internal use only.

It is a listing of account balances copied from the general ledger.

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Module 2 Test your knowledge solutions

1. Correct. Changes to revenue and expense accounts will affect owner's equity. Neither the Inventory nor
Cash accounts fall into this category. The purchase of inventory is not an expense because it is an investment
in an asset with future economic benefits.
2. Incorrect. Changes to revenue and expense accounts will affect owner's equity. The insurance expense will
decrease owners equity.
3. Incorrect. Withdrawal of capital by the owner will directly reduce the (Capital) or Equity account.
4. Incorrect. Changes to revenue and expense accounts will affect owner's equity. Interest earned is a revenue
item which affects owners equity.
1. Correct. The first journal entry, regarding prepaid insurance, has (presumably) posted a correct debit to
Insurance expense, and thus has correctly decreased owners equity. The incorrect posting of a credit to
Accounts receivable instead of Prepaid insurance does correctly affect Total assets since both of these
accounts still represent assets. The error in this first journal entry does not change the expected amount in an
equity account, and also does not under- or overstate Total assets.
The second journal entry was not posted, but should have been a debit to Prepaid advertising, an asset, and
a credit to Cash, also an asset. The expected result would have been no change to Total assets, and also no
change to equity because investment in the prepaid expense does not represent a true expense which
reduces equity. Therefore, the unposted second journal entry would not affect Total Assets in any event and
also does not affect equity because no expense was recognized.
2. Incorrect. The first journal entry has correctly decreased Owners Equity, and the unposted second entry
would not affect equity anyways because no expense was recognized. Therefore, the two errors do not
change the expected balance in Owners Equity.
3. Incorrect. The first journal entry has correctly decreased Owners Equity, and the unposted second entry
would not affect equity anyways because no expense was recognized.
4. Incorrect. The first journal entry has correctly decreased Owners Equity, and the unposted second entry
would not affect equity anyways because no expense was recognized.
1. Incorrect. The erroneous credit to Sales revenue overstates net income and owners equity.
2. Incorrect. The deposit should have credited Unearned revenue, thus increasing liabilities. Due to the error,
liabilities have been understated. The $80,000 value of the goods is not relevant here.
3. Incorrect. The erroneous credit to Sales revenue overstates net income and owners equity by $30,000. The
$80,000 value of the goods is not relevant here.
4. Correct. The correct journal entry should have been a debit of $30,000 to Cash and a credit to Unearned
revenue, a liability account, of the same amount. Due to the error, liabilities are understated because
Unearned revenue was never credited, net income is overstated because Sales revenue was erroneously
recognized, and Owners equity is also overstated due to the false increase in net income. The $80,000 value
of the goods is not relevant here since the customer did not make a deposit for this amount. Moreover, no
economic event has yet occurred that would warrant recognition of this value as sales revenue.
1. Correct. The correct journal entry should have debited Accounts payable by $3,500, thereby reducing
liabilities. The error debited an expense item instead, thereby reducing owners equity by the same amount.
Hence, liabilities are overstated and owners equity are understated.
2. Incorrect. The expected decrease to Accounts payable did not occur, therefore liabilities are overstated.
3. Incorrect. The direction of the errors impact is correct. However, the size of the impact is only $3,500.
Payment to the supplier reduces Accounts payable by $3,500 but erroneously increases Office expense by the
same amount, thereby reducing owners equity.
4. Incorrect. The expected decrease to Accounts payable did not occur, therefore liabilities are overstated.
Moreover, the size of the impact is only $3,500.

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1. Incorrect. Revenue is recognized when a sale is made, not when cash is received.
2. Incorrect. The 2% sales discount does not apply to the full $50,000 of sales because Earshot only made
payment in respect of $25,000 of sales within the 10-day discount period.
3. Correct. Earshot was able to take advantage of the 2% discount for paying a portion of Tivolis invoice within
10 days. However, this sales discount only applies to the actual amount reduced in Tivolis accounts
receivables, namely $25,000 2%, or $500. This debit to Sales discount is recorded in a contra revenue
account as an offset to Sales revenue. Tivolis increase in net income would be: $50,000 500 = $49,500.
4. Incorrect. As the vendor, Tivoli debits the Sales discount account as a contra against Sales revenue, thus
reducing net income from the sale.

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Example 2-1
Increases, decreases, and normal balances of accounts

This example demonstrates how increases or decreases in the balances of various types of accounts are expressed as either
debits or credits, as well as how to record the normal balance of each of these accounts.
Account

Type of
account

Increase

Decrease

Normal balance

a. Land

Asset

Debit

Credit

Debit

b. Harold Cooper, capital

Equity
capital*

Credit

Debit

Credit

c. Accounts receivable

Asset

Debit

Credit

Debit

d. Harold Cooper, withdrawals

Equity
withdrawal**

Debit

Credit

Debit

e. Cash

Asset

Debit

Credit

Debit

f. Equipment

Asset

Debit

Credit

Debit

g. Unearned revenue

Liability

Credit

Debit

Credit

h. Accounts payable

Liability

Credit

Debit

Credit

i. Postage expense

Equity
expense**

Debit

Credit

Debit

j. Prepaid insurance

Asset

Debit

Credit

Debit

k. Wages expense

Equity
expense**

Debit

Credit

Debit

l. Fees earned

Equity
revenue*

Credit

Debit

Credit

*Refer to Exhibit 3.8 on page 81. Capital and Revenues are types of Equity accounts. Increases in equity are always recorded
as credits; therefore, because owner investments and revenues cause equity to increase, increases in Capital and Revenue
are recorded as credits.
** Refer to Exhibit 3.8 on page 81. Withdrawals and Expenses are types of Equity accounts. Decreases in equity are always
recorded as debits; therefore, because withdrawals and expenses cause equity to decrease, increases in withdrawals and
expenses are recorded as debits.
Source: Larson and Jensen, Fundamental Accounting
, 10th Canadian edition ( 2002 McGraw-Hill Ryerson), Exercise 3-1, page 118.
Principles
Reproduced with permission.

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Exhibit 2-1: The accounting cycle (LEVEL 2)

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Problem 3-3B solution

Note: The account numbers in the PR column above would be included only when these journal entries are being posted in
Problem 3-4B. Assume that all entries were journalized on page 1 of the General Journal.

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Source: All solutions for textbook questions are from the Solutions Manual of Larson and Jensen,
Fundamental Accounting Principles
Canadian Edition ( 2007 McGraw-Hill Ryerson). Reproduced with permission.

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Example 2-2

Preparing a corrected trial balance

On January 1, 2011, Jan Taylor started a new business called The Party Place. Near the end of the year, she hired a new
bookkeeper without making a careful reference check. As a result, a number of mistakes have been made in preparing the
following trial balance:
The Party Place
Trial Balance
December 31
Debit
$ 5,500

Cash
Accounts receivable
Office supplies
Office equipment
Accounts payable
Jan Taylor, capital
Services revenue
Wages expense
Rent expense
Advertising expense
Totals

Credit
$ 7,900

2,650
20,500
9,465
16,745

$ 45,395

22,350
6,000
4,800
1,250
$ 52,340

Jan's analysis of the situation has uncovered these errors:

a. The sum of the debits in the Cash account is $37,175 and the sum of the credits is $30,540.
b. A $275 payment from a credit customer was posted to Cash but was not posted to Accounts receivable.
c. A credit purchase of office supplies for $400 was completely unrecorded.
d. A transposition error occurred in copying the balance of the Services revenue account to the trial balance. The correct
amount was $23,250.
Other errors were made in placing account balances in the trial balance columns and in taking the totals of the columns. Use
all of this information to prepare a correct trial balance.
Based on the errors uncovered, a corrected trial balance is prepared as follows:
THE PARTY PLACE
Trial Balance
December 31

Cash1
Accounts receivable2
Office supplies3
Office equipment
Accounts payable4
Jan Taylor, capital5
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Debit
$ 6,635
7,625
3,050
20,500

Credit

$ 9,865
16,745

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Services revenue6
Wages expense7
Rent expense7

6,000
4,800

Advertising expense7

1,250

Totals8

23,250

$ 49,860

$ 49,860

Notes:
1

The cash account was understated; the correct amount is determined by $37,175 $30,540.

The Accounts receivable account was placed in the wrong column and incorrectly posted. The correct
balance is determined by $7,900 $275.

The Office supplies account was understated because of the omitted transaction. The correct amount is
calculated as $2,650 + $400.

The Accounts payable account was understated because the credit purchase of office supplies was not
recorded. The correct amount is calculated as $9,465 + $400.

The Jan Taylor, capital account was placed in the wrong column.

Services revenue balance was transposed; the correct amount is $23,250.

All three expenses were placed in the wrong column.

The total of the debit and credit columns was incorrectly determined because account balances were in
error and in the wrong columns.

Source: Larson and Jensen, Fundamental Accounting

, 12th Canadian edition (2007 McGraw-Hill Ryerson), Problem 3-13B, pages 125-126,
Principles
with solution. Reproduced with permission.

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