Chapter 2 Notes

Double-Entry Accounting System

• For every transaction, total debits must equal total credits throughout the accounting period (January 1 to December 31).

• The double-entry accounting system requires at least one debit and at least one credit.

• The account's normal balance determines whether an account increases or decreases and which side of the T-account (debit or credit) to use.

Normal Balances

• Assets: Normal debit balance.

  • Increase asset accounts with debits.

  • Decrease asset accounts with credits.

• Expenses and Dividends: Normal debit balance.

  • Reduce equity balance.

  • Debit to recognize costs.

  • Debit when paying cash dividends to shareholders.

• Liabilities and Equity: Normal credit balance.

  • Liabilities: Payables (most) and unearned revenue.

    • Debit cash and credit unearned revenue when receiving cash in advance.

    • Reduce liabilities with debits.

  • Common Stock: Represents assets (cash or equipment) contributed to the company.

    • Debit cash or asset, credit common stock when issuing shares.

  • Retained Earnings: Net income minus dividends.

    • Credit retained earnings to reflect a net increase.

    • Closing Process: Transfer net income and dividends to retained earnings at the end of the accounting period.

    • Close temporary accounts (income statement accounts, revenues, and expenses).

Journalizing

• Step two of the accounting cycle: Constantly journalizing and posting entries to the general ledger.

• More than two accounts in an entry are allowed if debits equal credits.

• Transactions are reported in chronological order.

• The double-entry system helps identify and correct errors quickly.

• Each journal entry includes a date, at least one debit, and at least one credit.

• Explanations of transactions are not required for exams/quizzes if the transaction is provided.

• Reference column links entries to general ledger accounts.

• Issuing Common Stock Example: Shareholder gives $15,000; debit cash (company receives), credit common stock.

• The cash debit goes on the left side of the T-account. The common stock credit goes on the right side of the T-account.

• Repeat for all transactions throughout the year.

Ledger

• The ledger is a collection of all company accounts.

• The chart of accounts is a listing of account names and numbers. (Pioneer Advertising Example)

  • Assets: 100s.

  • Liabilities: 200s.

  • Equity: 300s.

  • Revenues: 400s.

  • Expenses: 600-999.

• Large companies may have millions of accounts, but accounting systems are computerized.

• Use the chart of accounts to determine which accounts should be debited or credited.

Posting

• Transfer debits and credits from journal entries to the ledger accounts (T-accounts).

• Example: Purchased office equipment for $50,000, signing a three-month, 12% note payable.

  • Debit equipment (asset).

  • Credit notes payable (liability).
    Equipment (+A) 50,000
    Notes Payable (+L) 50,000

• Post $50,000 to the debit side of the equipment T-account and the credit side of the notes payable T-account.

• Repeat for all transactions, maintaining account balances.

• Account balances are then transferred to an unadjusted trial balance.

Trial Balance

• The trial balance proves the equality of debits and credits.

• It's a check figure, but doesn't guarantee no errors (e.g., double entry, omitted entry).

• Example: Pioneer Advertising's unadjusted trial balance at 10/31/2025 shows total debits equal to total credits (periodicity assumption).

• Financial reporting periods: Monthly, quarterly, annually.

  • Public companies: Annual audited and quarterly unaudited financial statements.

• Cash has an $80,000 debit balance; unearned service revenue has a $12,000 credit balance.

Adjusting Entries

• Adjusting entries are needed to properly state assets, liabilities, revenues, and expenses.

• Exercise 2.1, solutions posted for self-study.

Revenue and Expense Recognition Principles

• Revenue Recognition: Recognize revenue when services are provided, even if cash hasn't been received.

• Expense Recognition: Match expenses to revenues generated in the same period.

  • Recognize wage expense for days worked, even if payment is in the next period.

  • Depreciation: Recognize wear and tear on assets; indirectly benefits revenue generation.

Supplies Example

• Supplies are prepaid assets. Initially, debit supplies and credit cash.

• At the end of the accounting period, determine how much supply is left.

• The difference between beginning supplies and what's remaining is the expense.

• Reduces the supplies account with a credit.

Other Adjustments

• Depreciation: Recognize monthly, quarterly, or annual depreciation expense.

  • Journal entry: Debit depreciation expense, credit accumulated depreciation.

• Insurance: Recognize consumed insurance coverage at the end of the period.

  • E.g., five months of insurance consumed from August 1 to December 31.

• Unreported Expenses: Recognize expenses even if the bill hasn't arrived.

  • Example: Electricity usage needs to be expensed even if the bill comes later.

Types of Adjusting Entries

• Deferrals: Expenses and revenues recognized after cash exchange.

  • Prepaid Assets: Recognize expense later.

    • Example: Bought $10,000 of supplies on June 1 (debit supplies, credit cash).

    • On December 31, recognize supplies expense for seven months of usage (deferring expense recognition until used).

  • Unearned Revenue: Recognize revenue upon service delivery.

    • Example: Receive cash for tax return prep in advance (debit cash, credit unearned revenue).

    • Recognize revenue after doing the tax return.

• Accruals: Expenses and revenues recognized before cash exchange.

  • Salaries, wages expense, accounts receivable, revenue, interest expense, interest revenue, and bad debt expense.

  • Credit Sales: Debit accounts receivable, credit revenue.

  • Bad Debt Expense: Estimate uncollectible accounts receivable based on history (debit bad debt expense, credit allowance for doubtful accounts).

Adjusting Entry Format and Rules

• Adjusting entries resemble regular journal entries (at least one debit, at least one credit).

• Adjusting entries never involve cash. There's at least one balance sheet account and one income statement account.

Income Statement Accounts

• Revenues and Expenses are income statement accounts. Do not confuse these with balance sheet accounts like unearned revenues which is a liability.

• After adjusting entries, prepare an adjusted trial balance to create financial statements.

Exercise 2.6: Adjusting Entries for a Dental Office

• Adjusting entries are prepared at the end of the period, right before financial statements.

• #1: Performed services for patients with dental insurance (January 31): $750 of services performed but not yet billed.

  • Debit accounts receivable $750, credit service revenue $750.

  • Accrual adjusting entry.

  • Assets and net income would be understated if not recorded.

• #2: Utility expenses incurred but not paid by January 31: $520.

  • Debit utility expense $520, credit utilities payable $520.

  • Net income would be overstated and liabilities understated if not recorded.

• 3: Purchased dental equipment on January 1 for $80,000 (20,000 in cash and a $60,000 three-year note payable).

  • Equipment depreciates at $400 per month. Interest is $500 per month.

  • Two different adjusting entries needed.

    • a. Depreciation: Debit depreciation expense $400, credit accumulated depreciation $400.

    • Net income overstated, and assets overstated without this entry.

    • b. Accrued Interest: Debit interest expense $500, credit interest payable $500.

• #4: Purchased a one-year malpractice insurance policy on January 1 for $12,000.

  • Debit insurance expense $1,000, credit prepaid insurance $1,000 (12,000/12 = 1,000 of expense).

  • The balance of the prepaid insurance account would be $11,000 ($12,000 - $1,000) after January 31.

• #5: Purchased $1,600 of dental supplies, $500 of supplies remains.

  • Debit supplies expense $1,100, credit supplies $1,100. The remaining balance in the supplies account is $500.

Exercise 2.8: Adjusting Entries for Ace Computer Services

• #1: August 31: Radek owed employees $1,900 in wages to be paid on September 1.

  • Debit salaries and wages expense $1,900, credit salaries and wages payable $1,900.

  • This is an accrual.

  • Net income and equity would be overstated without this entry; liabilities would be understated without the adjusting entry.

• #2: Not yet received the month's utility bill, estimated to be approximately $600.

  • Debit utilities expense $600, credit utilities payable $600.

  • Income statement account and a balance sheet account.

  • Net income and equity would be overstated without this adjusting entry; liabilities would be understated without the adjusting entry.

• #3: August 1: Borrowed $30,000 from a local bank on a fifteen-year mortgage with an annual interest rate of 8%.

  • Debit interest expense $200, credit interest payable $200 (30,000 x 0.08 x 1/12 = $200).

• #4: Telephone bill for $117 covering August charges is unpaid at August 31.

  • Debit telephone and internet expense $117, credit accounts payable $117.

  • Recognized an expense in every situation before paying with cash.

Salaries Example Continued

*On Friday, 12/26/2023, BP Incorporated paid its employees $700 for the preceding two-week pay period. The following week, BP's employees, work three days prior to the close of 2023 accounting period. (29th, 30th, & 31st). Analyze the information to address the following questions:
*Prepare the adjusting entry, if any, that is needed to accrue salaries expense on 12/31/2023.
*What account(s) will be debited and credited when the salaries and wages are paid to BP's employees on 01/09/2024

• On Friday, 12/26/2023, a $700 salaries expense was paid for a two-week pay period.

• Employees worked three days before year-end (12/29, 12/30, 12/31), creating an accrued expense.
  *700USD pay for 2 weeks (10 working days)
  *700USD / 10USD = 70USD per day
  *12/29 --> 1/9 = 3 working days = 210USD
  *1/1--> 1/9 = 7 working days = 490USD

• Adjusting Entry (12/31/2023):

  • Debit salaries and wages expense, credit salaries and wages payable: Accruing the liability because they're not paid until January, 2024.

  • Calculate expense: Three days of work are $210 in wages for the accrual.

• Journal Entry (01/09/2024) Payday:

  • Reduce liability, by reversing and debiting Salaries and Wages Payable. Recognize all that has already been paid by crediting Cash.

  • $210 + $490 = Expense + Payment (of both wages for this year and resolving of the liability set up in last year's accrual.

Financial Statements

• Prepared from the adjusted trial balance: Income statement, statement of stockholders' equity, balance sheet, statement of cash flows.

• Income Statement: Revenues minus expenses equals net income (Chapter 3).

• Retained Earnings Statement: Optional, reflects changes in retained earnings (net income/loss and dividends).

• Balance Sheet: Reflects the accounting equation (Chapter 4).

• Statement of Cash Flows: Deferred for later (July or Fall).

Closing Process

• Done after financial statements to prepare for the next accounting period.

• Only applies to temporary accounts (revenues, expenses, and dividends) to have accounts at zero.

• Goals: Zero out temporary accounts, transfer net income/loss and dividends to retained earnings.

Income Summary Account

• The income summary account is only used during the closing process.

• Transfer the credit balance (net income) into retained earnings, and a debit balance occurs when paying back out in a cash dividend.

• Closing entries are posted to the accounts ledger.

• To close revenue accounts, debit each individual account to zero it out and transfer total credit balance into the income summary.

• For expenses (normal debit balance), credit the accounts to zero balance.

Four-Step Closing Process

• Step 1: Close revenue accounts to income summary. Debit revenue accounts and credit income summary.

• Step 2: Close expense accounts (and contra-revenue accounts like sales discounts, sales returns, and allowances) to income summary. Credit the expense and contra-revenue accounts, debit income summary.

*Contra-Revenue (Sales Discounts, Sales Returns & Allowances)
*Reduce Gross Sales from Customer returns from refunds or discounts when minor defects in service are present. Sales discounts are enticements for prompt payments as % incentives when customers pay within 10-15 days of delivery.

• After this step, the net balance of income summary should be equal to net income (Revenues-Expenses=Net-Income).

• Step 3: Close income summary to retained earnings to transfer net income. Debit income summary, credit retained earnings.

• Step 4: Close dividends to retained earnings. Credit dividend accounts (normal debit balance implies a reduction). Debit retained earnings.

Exercise 2.16: Closing Entries

• Account balances for Winslow Co., as of 12/31/2025.

• Step 1: Close Revenue Accounts
  12/31/2025 Debit Sales Revenue: Credit the Balance Sheet as $$$4.10.000 by Credit Income summary, Debit Cash
  *Step 2: Normal Debit Balances are closed out for expenses and contra revenue accounts to be moved into Income Statement

Post Closing Trial Balance

This post closing trial balances includes the following expenses:
*Debit Sales, Returns & Allowances (12,000)
Sales Discounts(15,000)
COGS (225,700)
Selling Expenses(16,000)
Administrative Expenses(38,000)
Income Tax Expense(30,000)
Total Debit for closed of temporary files and total expenses equals, Debit Income Summary (336,700).

Total Credit Balance: is ( $73,300)
To accurately review all Income Statements, you must include the Net Income.

• Next step is to formally transfer Net Income into Retained Earnings.

Retained Earnings must be retained to keep financial statements from previous quarters accurate. This step is to show the Net Income against those accurate historic Financials and balance those with Dividends that may have already been paid out.

1. Debit income summary which should tie to net income to accurately increase the balance sheet( Debit $73,330)

2. Credit: Retained Earnings as increased balance of the net income. Increases from this point forward needs to be accurate.
   (Net income is + Retained Earnings , while Dividends are - Reductions. Reductions should be included to retain original, previous amounts retained accurately.
   The Debit and Income Summary with +Retained Earnings, is the number with which this and later totals must be reconciled.
   *Lastly, Credit side entries will also need to reflect:

3. closing out Cash Dividends

4. Crediting side of dividends also needs to reflect a reduced retained earnings. (Debited Cash (18,000). This will conclude with:
   -Accounting in the clear.

Final results should then produce these accounts:
*Accounts in the Clear that reflect an honest and accurate snapshot of financials as:
1. Retained Earnings (Begin: 45,000 + Credit Incomes: $73, 300 + - Debit Dividends of 18,000 for Total Balance that properly displays the Financials @ an Accurate display of both historic reports with Accurate, Honest Current Reports.

Reverse Entries

• Rules for reversing entries:

  • Reversing entries are optional.

  • All accrual adjusting entries are reversed.

  • For deferrals (prepaid assets and unearned revenues):

    • If the company has recognized the revenue or expense in the original transaction, the adjusting entry will be reversed.

    • If they recognize prepaid assets and recognize unearned revenue, there is no reversing entry.