Notes on Double-Entry Accounting & The Accounting Cycle

Learning Objectives

• Identify the steps in the accounting cycle.

• Explain how accounts, debits, and credits are used to record transactions using double-entry bookkeeping.

• Journalize transactions in the general journal.

• Explain the purpose of a trial balance.

• Prepare a basic set of financial statements from a trial balance.

Past Approach vs Double-Entry

• The Accounting Equation template was used for analysis, but double-entry bookkeeping with journal entries and the accounting cycle is the common practice.

Limitations of Accounting Equation Template Approach

• Formatting: Number of accounts is limited; spreadsheets become large, hard to print, read, and interpret.

• Income Statement Preparation: Difficult and inefficient to quantify grouped revenue and expense totals.

Types of Accounting Systems

• 1) Accounting Equation Template Approach

• 2) "Double-Entry" Accounting System

• Both are based on the Accounting Equation, which must ALWAYS stay in BALANCE:
  $\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}$

Retained Earnings: Concept and Calculation

• Represents accumulated earnings kept in the business.

• Its change over a period:
  $\text{Retained Earnings}*<em>{t} = \text{Retained Earnings}*</em>{t-1} + \text{Net Income} - \text{Dividends Declared}$

• Net Income increases Retained Earnings; Dividends Declared decrease it.

The Accounting Cycle and Double-Entry System

• After analyzing transactions with the ACCOUNTING EQUATION, transactions are recorded in accounts held in the general journal using double-entry bookkeeping as Journal Entries.

• The output from the ACCOUNTING CYCLE is the Financial Statements.

Analyzing & Recording Transactions (Steps 1

–4)

• Step 1: Which accounts are affected? (At least two accounts must be affected, chosen from a Chart of Accounts).

• Step 2: Type of accounts? (Asset, Liability, Equity, Revenue, Expense, Dividends Declared).

• Step 3: Increase or decrease?

• Step 4: Do we add Debits or Credits? Rule: Total Debits = Total Credits.

Chart of Accounts

• A list of accounts a company uses to record transactions, numbered by type (assets, liabilities, equity, revenues, expenses).

Journal Entry: Key Elements

• Date, Account Names involved, Total Debits = Total Credits, Short Description, Posting Reference.

Debits and Credits: T-Accounts

• Assets: Debit increases, Credit decreases.

• Liabilities and Equity: Credit increases, Debit decreases.

• Debits are always on the left and credits on the right.

Normal Balances

• The side with the "normal" balance is also the side that increases the account’s balance.

• Example: Contra-Asset accounts (e.g., accumulated depreciation) reduce assets and thus have a credit normal balance.

“Posting” Journal Entries

• Posting is the process of transferring journal entry amounts to the general ledger accounts.

• Posting Reference (PR) provides an audit trail.

Calculating Account Balances

1. Add the amounts on the debit side.

2. Add the amounts on the credit side.

3. Calculate the difference between the debits and credits.

4. Put the balance on the side with the larger number.

5. Check if the account has a “normal balance.”

The Trial Balance

• A listing of the ending balance in each general ledger account at a specific point in time.

• Purpose: To ensure Debits = Credits and to facilitate financial statement preparation.

Conclusion

• Double-entry accounting ensures the accounting equation remains in balance, supports audit trails through posting references, and underpins the reliable generation of financial statements.