Chapter 3: Double-Entry Accounting and the Accounting Cycle
Learning Objectives
LO1: Explain how the double-entry accounting system works, including how it overcomes the limitations of the template approach.
LO2: Explain the normal balance concept and how it is used within the double-entry accounting system.
LO3: Identify and explain the steps in the accounting cycle.
LO4: Explain the significance of a company’s decisions regarding its chart of accounts and the implications of subsequent changes.
LO5: Explain the difference between permanent and temporary accounts.
LO6: Identify and record transactions in the general journal and general ledger.
LO7: Explain why adjusting entries are necessary and prepare them.
LO8: Explain why closing entries are necessary and prepare them.
Double-Entry Accounting System
The double-entry accounting system captures information effectively by ensuring each transaction is recorded in at least two accounts.
Each transaction amount is recorded twice—once as a debit and once as a credit.
Accounting Equation: Assets = Liabilities + Shareholders' Equity. Total debits must always equal total credits, maintaining the balance of this equation.
Normal Balance Concept
Normal Balances: Every account has a normal balance, either debit or credit:
Asset Accounts: Normal balance is debit; increases recorded as debits.
Liability and Shareholders’ Equity Accounts: Normal balance is credit; increases recorded as credits.
Revenue Accounts: Normal balance is credit; increases are credited.
Expense and Dividend Accounts: Normal balance is debit; increases are debited.
To decrease an account, the opposite type of entry is used (e.g., credit to decrease an asset).
The Accounting Cycle
Transaction Analysis: Understanding which accounts are impacted and to what extent.
Recording Transactions: Initially in the general journal and subsequently in the general ledger.
Posting to the General Ledger: Information is transferred from journal entries to specific accounts in the ledger.
Trial Balance Preparation: A trial balance ensures total debits equal total credits at a specific time.
Adjusting Entries: Necessary adjustments are made at the end of the accounting period.
Financial Statement Preparation: Financial statements are generated from the adjusted trial balance.
Closing Entries: Temporary accounts are closed to retained earnings at year-end.
Types of Accounts
Permanent Accounts
Include assets, liabilities, and shareholders' equity accounts.
Balances carry over from one period to the next.
Temporary Accounts
Include revenues, expenses, and dividends declared.
Begin and end with a zero balance at the start and close of each period.
Transactions and Journal Entries
Each transaction is evidenced by source documents and involves analyzing the impact on relevant accounts.
Transactions recorded should meet the key points of journal entry formatting: debits before credits, indented credits, and equal total dollar values for debits and credits.
Examples of Transactions
Share Issuance: Assets (Cash) and Shareholders’ Equity (Common Shares) increased by $250,000.
Bank Loan: Cash increased by $100,000; Liabilities (Bank Loan Payable) increased by $100,000.
Rent Payment: Assets (Cash) decreased by $1,100; Expenses (Rent Expense) increased by $1,100.
Equipment Purchase: Assets (Equipment) increased by $65,000; Cash decreased by $65,000.
Insurance Policy Purchase: Cash decreased by $1,800; Prepaid Insurance increased by $1,800.
Land Purchase: Cash decreased by $180,000; Land increased by $180,000.
Inventory Purchase on Credit: Inventory increased by $23,000; Liabilities (Accounts Payable) increased by $23,000.
Closing Entries with Journal Entries
Closing entries are necessary at the end of an accounting period to reset the balances of temporary accounts to zero, allowing them to begin the next period afresh. Temporary accounts include revenues, expenses, and dividends declared. The closing process involves:
Closing Revenue Accounts: Transfer the balance of revenue accounts to the Income Summary account.
Closing Expense Accounts: Transfer the balance of expense accounts to the Income Summary account.
Closing Income Summary: Determine the net income (or loss). If there’s a net income, debit Income Summary and credit Retained Earnings; if there’s a net loss, credit Income Summary and debit Retained Earnings.
Journal Entry for Net Income:
Dr. Income SummaryCr. Retained Earnings
Journal Entry for Net Loss:
Dr. Retained EarningsCr. Income Summary
Closing Dividends: Transfer the balance of the Dividends account to Retained Earnings.
This process ensures that all temporary accounts reflect a balance of zero at the beginning of the next accounting period, facilitating accurate financial report generation.
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