CHAPTER 2: THE ACCOUNTING CYCLE

DURING THE PERIOD

1
 Functions of Financial Accounting

(1) Measure business activities of the company.

• Record transactions

(2) Communicate measurements to external parties for decision

making.
• Prepare financial statements

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PART A:
MEASURING BUSINESS ACTIVITIES

3
 Key Point

 External transactions are transactions between the company

and a separate company or individual.

 Internal transactions do not include an exchange with a

separate economic entity.

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Six Steps in Measuring External Transactions

Step 1 • Use source documents to identify accounts affected

by an external transaction.
Step 2 • Analyze the impact of the transaction on the
accounting equation.
Step 3 • Assess whether the transaction results in a debit or
credit to account balances.
Step 4 • Record the transaction in a journal using debits and
credits.
Step 5 • Post the transaction to the general ledger.
Step 6 • Prepare a trial balance.

2-5
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 Capturing Transactions in Accounts

 Account: Record of all transactions related to a particular item over a period of time.
– Asset accounts:
Examples: Cash, Supplies, and Equipment
– Liability accounts:
Examples: Accounts Payable, Salaries Payable, Utilities Payable, and Taxes Payable
– Stockholders’ equity accounts:
Examples: Common Stock and Retained Earnings
 Chart of accounts: A list of all account names used to record transactions

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 Key Point

 The six-step measurement process (Illustration 2–1) is the foundation of financial

accounting.
 To understand this process, it is important to realize in Step 2 that we analyze the
effects of business transactions on the accounting equation (Part A of this chapter).
 Then, in Step 3 we begin the process of translating those effects into the accounting
records (Part B of this chapter).

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 Effects of Transactions on the Basic Accounting Equation

Each transaction will have a dual effect on the

basic accounting equation

Assets = Liabilities + Stockholders’ Equity

(creditors’ claims) (owners’ claims)

Resources Claims to Resources

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 Understanding Effects of Transaction

 For each transaction, ask these three questions:

1. What is one account affected by the transaction?
• Does this account increase or decrease?
2. What is a second account affected by the transaction?
• Does this account increase or decrease?
3. Do assets equal liabilities plus stockholders’ equity?
• THEY MUST!! EVERY TIME!!

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External Transactions of Eagle Soccer Academy

Transaction Date Description

(1) Dec. 1 Sell shares of common stock for $200,000 to obtain the funds
necessary to start the business.
(2) Dec. 1 Borrow $100,000 from the local bank and sign a note
promising to repay the full amount of the debt in three years.
(3) Dec. 1 Purchase equipment necessary for giving soccer training.
$120,000 cash.
(4) Dec. 1 Pay one year of rent in advance, $60,000 ($5,000 per month).
(5) Dec. 6 Purchase supplies on account, $23,000.
(6) Dec. 12 Provide soccer training to customers for cash, $43,000.
(7) Dec. 17 Provide soccer training to customers on account, $20,000.
(8) Dec. 23 Receive cash in advance for 12 soccer training sessions to be
given in the future, $6,000.
(9) Dec. 28 Pay salaries to employees, $28,000.
(10) Dec. 30 Pay cash dividends of $4,000 to shareholders.

2-10
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 Transaction (1): Issue Common Stock (1 of 3)
Sell shares of common stock for $200,000 to obtain the funds necessary to start the business.

• What is one account affected by the transaction?

– Cash
• Does that account increase or decrease?
– Increase by $200,000
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 Transaction (1): Issue Common Stock (2 of 3)
Sell shares of common stock for $200,000 to obtain the funds necessary to start the business.

• What is a second account affected by the transaction?

– Common Stock
• Does that account increase or decrease?
– Increase by $200,000
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 Transaction (1): Issue Common Stock (3 of 3)

Sell shares of common stock for $200,000 to obtain the funds

necessary to start the business.

Assets = Liabilities + Stockholders’ Equity

Cash Common Stock
(1) +$200,000 = +$200,000

 Do assets equal liabilities plus stockholders’ equity?

– Yes, assets increase by $200,000 and stockholders’ equity increases
by $200,000
2-13
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 Common Mistake

It’s sometimes tempting to decrease cash as a way of recording an

investor’s initial investment.

However, remember we account for the transactions from the

company’s perspective, and the company received cash from the
stockholder—an increase in cash.

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 Transaction (2): Borrow Cash from the Bank

Borrow $100,000 from the local bank and sign a note promising to repay the full amount of the
debt in three years.

Assets = Liabilities + Stockholders’ Equity

Cash Notes Payable Common Stock
Bal. $200,000 $200,000
(2) +$100,000 +$100,000
Bal. $300,000 $100,000 $200,000
$300,000 = $300,000
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 Key Point

After each transaction, the accounting equation must always remain

in balance. In other words, assets must always equal liabilities plus
stockholders’ equity.

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 Transaction (3): Purchase Equipment
Purchase equipment necessary for giving soccer training, $120,000 cash.

Assets = Liabilities + Stockholders’ Equity

Cash Equipment Notes Payable Common Stock
Bal. $300,000 $100,000 $200,000
(3) –$120,000 +$120,000
Bal. $180,000 $120,000 $100,000 $200,000
$300,000 = $300,000

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 Transaction (4): Pay for Rent in Advance
Pay one year of rent in advance, $60,000 ($5,000 per month).

Assets = Liabilities + Stockholders’ Equity

Prepaid Notes
Cash Equipment
Rent Payable Common Stock
Bal. $180,000 $120,000 $100,000 $200,000
(4) –$ 60,000 +$60,000
Bal. $120,000 $60,000 $120,000 $100,000 $200,000

$300,000 = $300,000
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 Transaction (5): Purchase Supplies on Account

Purchase supplies on account, $23,000.

Assets = Liabilities + Stockholders’ Equity

Prepaid Accounts Notes
Cash Supplies Rent Equipment Payable Payable Common Stock
Bal. $120,000 $60,000 $120,000 $100,000 $200,000
(5) +$23,000 +$23,000
Bal. $120,000 $23,000 $60,000 $120,000 $23,000 $100,000 $200,000
$323,000 = $323,000

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Expanded Accounting Equation

Basic
Accounting
Equation

Expanded
Accounting
Equation

2-20
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 Key Point

 The expanded accounting equation demonstrates that revenues

increase retained earnings while expenses and dividends decrease
retained earnings.

 Retained earnings is a component of stockholders’ equity.

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 Transaction (6): Provide Services for Cash

Provide soccer training to customers for cash, $43,000.

Assets = Liabilities + Stockholders’ Equity

Prepaid Accounts Notes Common Retained
Cash Supplies Rent Equipment Payable Payable Stock Earnings
Bal. $120,000 $23,000 $60,000 $120,000 $23,000 $100,000 $200,000 Service
(6) +$43,000 +$43,000 Revenue
Bal. $163,000 $23,000 $60,000 $120,000 $23,000 $100,000 $200,000 $43,000
$366,000 = $366,000

2-22
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 Transaction (7): Provide Services on Account

Provide soccer training to customers on account, $20,000.

Assets = Liabilities + Stockholders’ Equity

Accounts Prepaid Accounts Notes Common Retained
Cash Receivable Supplies Rent Equipment Payable Payable Stock Earnings
Bal. $163,000 $23,000 $60,000 $120,000 $23,000 $100,000 $200,000 $43,000
Service
(7) +$20,000 +$20,000
Revenue
Bal. $163,000 $20,000 $23,000 $60,000 $120,000 $23,000 $100,000 $200,000 $63000
$386,000 = $386,000

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 Transaction (8): Receive Cash in Advance from Customers

Receive cash in advance for 12 soccer training sessions to be given in the future, $6,000.

Assets = Liabilities + Stockholders’ Equity

Accounts Prepaid Accounts Deferred Notes Common Retained
Cash Receivable Supplies Rent Equipment Payable Revenue Payable Stock Earnings
Bal. $163,000 $20,000 $23,000 $60,000 $120,000 $23,000 $100,000 $200,000 $63,000
(8) +$ 6,000 $6,000
Bal. $169,000 $20,000 $23,000 $60,000 $120,000 $23,000 $6,000 $100,000 $200,000 $63,000
$392,000 = $392,000

2-24
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 Common Mistake

Don’t let the account name fool you.

Even though the term revenue appears in the account title for
deferred revenue, this is NOT a revenue account.

Deferred indicates that the company has yet to provide services even
though it has collected the customer’s cash.
The company owes the customer a service, which creates a liability.

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consent of McGraw-Hill .
 Transaction (9): Pay Salaries to Employees

Pay salaries to employees, $28,000.

Assets = Liabilities + Stockholders’ Equity

Accounts Prepaid Accounts Deferred Notes Common Retained
Cash Receivable Supplies Rent Equipment Payable Revenue Payable Stock Earnings
Bal. $169,000 $20,000 $23,000 $60,000 $120,000 $23,000 $6,000 $100,000 $200,000 $63,000
(9) –$28,000 –$28,000Salaries
Expense
Bal. $141,000 $20,000 $23,000 $60,000 $120,000 $23,000 $6,000 $100,000 $200,000 $35,000
$364,00 = $364,000

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 Transaction (10): Pay Cash Dividends
Pay cash dividends of $4,000 to stockholders.

Assets = Liabilities + Stockholders’ Equity

Accounts Prepaid Accounts Deferred Notes Common Retained
Cash Receivable Supplies Rent Equipment Payable Revenue Payable Stock Earnings
Bal. $141,000 $20,000 $23,000 $60,000 $120,000 $23,000 $6,000 $100,000 $200,000 $35,000
(10)–$ 4,000 –$ 4,000 Dividends
Bal. $137,000 $20,000 $23,000 $60,000 $120,000 $23,000 $6,000 $100,000 $200,000 $31,000
$360,000 = $360,000
2-27
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 Common Mistake

 Students often believe a payment of dividends to owners increases

stockholders’ equity.

 Remember, you are accounting for the resources of the company.

 While stockholders have more personal cash after dividends have been paid,
the company in which they own stock has fewer resources (less cash).

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 Summary of All 10 External Transactions

Liabilities
Assets = + Stockholders' Equity

Accounts Accounts Deferred Common Retained

Cash Receivables Supplies Prepaid Rent Equipment Payable Revenue Notes Payable Stock Earnings
Dec. 1 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0
+200,000
(1) +200,000
+100,000 +100,000
(2)
-120,000 +120,000
(3)
-60,000 +60,000
(4)
(5) +23,000 +23,000
Service
(6) +43,000 +43,000 Revenue

Service
(7) +20,000 +20,000 Revenue
+6,000 +6,000
(8)
Salaries
(9) -28,000 -28,000 Expense

(10) -4,000 -4,000 Dividends

Dec. 31 $137,000 $20,000 $23,000 $60,000 $120,000 $23,000 $6,000 $100,000 $200,000 $31,000
$360,000 = $360,000

2-29
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PART B:
DEBITS AND CREDITS

30
Debit and Credit Effects on Accounts in the Basic
Accounting Equation

1. Left side—Assets increase with debits.

2. Right side—Liabilities and stockholders’ equity
increase with credits.
• The opposite is true to decrease the balance of any of
these accounts.

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 Common Mistake

 Some students think the term “debit” always means increase, and
“credit” always means decrease.
 While this is true for assets, it is not true for liabilities and
stockholders’ equity.
 Liabilities and stockholders’ equity increase with a credit and
decrease with a debit.

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 Key Point

For the basic accounting equation:

 (Assets = Liabilities + Stockholders’ Equity), assets (left side)

increase with debits.
 Liabilities and stockholders’ equity (right side) increase with credits.
The opposite is true to decrease any of these accounts.

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Debit and Credit Effects on Accounts in
the Expanded Accounting Equation

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 Key Point

 The Retained Earnings account is a stockholders’ equity account

that normally has a credit balance.
 The Retained Earnings account has three components—revenues,
expenses, and dividends.
 The difference between revenues (increased by credits) and
expenses (increased by debits) equals net income.
 Net income increases the balance of Retained Earnings.
 Dividends (increased by debits) decrease the balance of Retained
Earnings.

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 Debit and Credit Effects on Each Account Type

A simple memory aid

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Format for Recording a Business Transaction, or
Journal Entry

Date Debit Credit

Account Name ....................................... Amount
Account Name.................................. Amount
(Description of transaction)

• Prior to the widespread use of computers, companies

recorded their transactions in paper-based journals. Thus,
the term journal entry.

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 Recording Transactions—Example

 On December 1, Eagle Soccer Academy sells shares of common stock to

investors for cash of $200,000.
– Debit to Cash for $200,000
– Credit to Common Stock for $200,000

December 1 Debit Credit

Cash (+A).................................................. 200,000
Common Stock (+SE).......................... 200,000
(Issue common stock for cash)

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 Key Point

For each transaction, total debits must equal total credits.

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 Common Mistake

 Students sometimes hear the phrase “assets are the debit accounts” and
believe it indicates that assets can only be debited. This is incorrect! Assets,
or any account, can be either debited or credited. Rather, this phrase
indicates that debiting the asset account will increase the balance and that
an asset account normally will have a debit balance.
 Similarly, the phrase “liabilities and stockholders’ equity are the credit
accounts” does not mean that these accounts cannot be debited. They will
be debited when their balances decrease. Rather, the phrase means that
crediting the liabilities and stockholders’ equity accounts increases their
balances, and they normally will have a credit balance.

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 General Ledger Account

 Posting is the process of transferring the debit and credit information from the journal to
individual general ledger accounts.
 The general ledger provides, in a single collection, each account with its individual
transactions and resulting account balance.

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• On December 1, Eagle Soccer Academy sells shares of common
stock to investors for cash of $200,000.
(1) December 1 Debit Credit
Cash (+A)................................................................. 200,000
Common Stock (+SE)....................................... 200,000
(Issue common stock for cash)

Account: Cash
Date Descriptions Debit Credit Balance
Dec. 1 Beginning Balance 0
Dec. 1 Issue common stock for cash 200,000 200,000

Account: Common Stock

Date Descriptions Debit Credit Balance
Dec. 1 Beginning Balance 0
Dec. 1 Issue common stock for cash 200,000 200,000

Posting Transaction to Accounts (1 of 10) 2-42

• On December 1, Eagle borrows cash from a bank, $100,000.
(2) December 1 Debit Credit
Cash (+A)................................................................. 100,000
Notes Payable (+L)…........................................ 100,000
(Borrow cash by signing three-year note)

Account: Cash
Date Descriptions Debit Credit Balance
Dec. 1 Beginning balance 0
Dec. 1 Issue common stock for cash 200,000 200,000
Dec. 1 Borrow cash by signing note 100,000 300,000

Account: Notes Payable

Date Descriptions Debit Credit Balance
Dec. 1 Beginning balance 0
Dec. 1 Borrow cash by signing note 100,000 100,000

Posting Transaction to Accounts (2 of 10) 2-43

 T-account
A T-account includes the account title at the top, one side for recording
debits, and one side for recording credits.
• The left side of the T-account is the debit column.
• The right side is the credit column.
Here are the T-accounts for Cash and Notes Payable after posting
transaction (2).

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• On December 1, Eagle purchases equipment with cash, $120,000.
(3) December 1 Debit Credit
Equipment (+A)....................................................... 120,000
Cash (−A)…………………....................................... 120,000
(Purchase equipment with cash)

• T-account: Simplified version of general ledger account

• Includes the account title at the top, left side for recording debits,
and right side for recording credits
Equipment Cash
(3) 120,000 (1) 200,000 (3) 120,000
(2) 100,000

Bal. 120,000 Bal. 180,000

Posting Transaction to Accounts (3 of 10)

2-45
 Key Point

Posting is the process of transferring the debit and credit information from
transactions recorded in the journal to individual accounts in the general ledger.

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Summary of Journal Entries Recorded for Transactions of Eagle Soccer Academy

(1) December 1 Debit Credit

Cash (+A) ……..……………………………………………………….. 200,000
Common Stock (+SE) ……………………………………. 200,000
(Issue common stock for cash)
(2) December 1 Debit Credit
Cash (+A) ……..……………………………………………………….. 100,000
Notes Payable (+L) ………………………………………… 100,000
(Borrow cash by signing three-year note)
(3) December 1 Debit Credit
Equipment (+A) ..…..………………………………………………. 120,000
Cash (−A) ……………………………….……………………… 120,000
(Purchase equipment with cash)
(4) December 1 Debit Credit
Prepaid Rent (+A) ….…………………………………….…………. 60,000
Cash (−A) ……………………………….……………………….. 60,000
(Prepay rent with cash)
Continued

2-47
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Summary of Journal Entries Recorded for Transactions of Eagle Soccer Academy

(5) December 6 Debit Credit

Supplies (+A) .……………………………………………….……… 23,000
Accounts Payable (+L) .………………………………… 23,000
(Purchase supplies on account)
(6) December 12 Debit Credit
Cash (+A)……..……………………………………………….……… 43,000
Service Revenue (+R, +SE) …………………………… 43,000
(Provide training to customers for cash)
(7) December 17 Debit Credit
Accounts Receivable (+A)……..………….……….….………. 20,000
Service Revenue (+R, +SE) ………………………….… 20,000
(Provide training to customers on account)
(8) December 23 Debit Credit
Cash (+A) ……………………………..………….……….….………. 6,000
Deferred Revenue (+L) …………………..……………. 6,000
(Receive cash in advance from customers)
Continued

2-48
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Summary of Journal Entries Recorded for Transactions of Eagle Soccer Academy

(9) December 28 Debit Credit

Salaries Expense (+E, −SE) ..…..……………………….… …… 28,000
Cash (−A) …..…………………………..……………………… 28,000
(Pay salaries to employees)

(10) December 30 Debit Credit

Dividends (+D, −SE) ……………..………….……….….……...... 4,000
Cash (−A) …..…………………………..…………………….... 4,000
(Pay cash dividends)

2-49
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Posting of External Transactions of Eagle Soccer Academy from
Journal Entries to General Ledger Accounts

Assets = Liabilities + Stockholders’ Equity

Accounts Accounts Common Retained
Cash Receivable Payable Stock Earnings
(1) 200,000 (3) 120,000 (7) 20,000 (5) 23,000 (1) 200,000 0
(2) 100,000 (4) 60,000
(6) 43,000 (9) 28,000 Bal. 20,000 Bal. 23,000 Bal. 200,000 0
(8) 6,000 (10) 4,000
Bal. 137,000

Prepaid Deferred Service Salaries

Supplies Rent Revenue Revenue Expense
(5) 23,000 (4) 60,000 z
(8) 6,000 (6) 43,000 (9) 28,000
(7) 20,000
Bal. 23,000 Bal. 60,000 Bal. 6,000 Bal. 63,000 Bal. 28,000

Notes
Equipment Payable Dividends
(3) 120,000 (2) 100,000 (10) 4,000

Bal. 120,000 Bal. 100,000 Bal. 4,000

Transaction numbers are shown in parentheses. Account balances are in bold.

2-50
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 Trial Balance

 A trial balance is a list of all accounts and their balances at a

particular date, showing that total debits equal total credits.
 Another purpose of the trial balance is to assist us in preparing
adjusting entries for internal transactions (Chapter 3).
 Used for internal purposes only
– Not published to external parties
– Not required to follow an order of listing

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 Common Mistake

Just because the debits and credits are equal in a trial balance does not
necessarily mean that all balances are correct.
A trial balance could contain offsetting errors.
For example, if we overstate cash and revenue each by $1,000:
 Both accounts will be in error.
 But the trial balance will still balance, since the overstatement to cash
increases debits by $1,000 and the overstatement to revenue increases credits
by $1,000.

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Trial Balance of Eagle Soccer Academy

EAGLE SOCCER ACADEMY

Trial Balance
December 31, 2024
Accounts Debit Credit
Cash $ 137,000
Accounts Receivable 20,000
Supplies 23,000
Prepaid Rent 60,000
Equipment 120,000
Accounts Payable $ 23,000
Deferred Revenue 6,000
Notes Payable 100,000
Common Stock 200,000
Retained Earnings 0
Dividends 4,000
Service Revenue 63,000
Salaries Expense 28,000
Totals $392,000 $392,000
2-53
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 Order of Accounts

 The trial balance is used for internal purposes only and

provides a check on the equality of the debits and credits.
 The trial balance simplifies preparation of the published
financial statements.

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END OF CHAPTER 2

55