A Decision-Making Approach,
2nd Edition
King, Lembke, and Smith
*
Prepared by
Dr. Denise English,
Boise State University

CHAPTER
SEVEN
After reading Chapter 7, you should be able to:
1. State how the accounting system relates to the accounting process and how it is designed to provide useful information to decision makers.
2. Describe how the accounting equation is useful in understanding and communicating the effects of different transactions and events.
3. Explain how ledger accounts are used to process information about transactions and events to facilitate financial decisions.
4. Discuss the benefits of the double-entry bookkeeping system for financial statement users.

CHAPTER
SEVEN
After reading Chapter 7, you should be able to:
5. Differentiate between permanent and temporary accounts and explain how the differences in these accounts relate to the types of decisions financial statement users make.
6. Describe the role that each of the accounting cycle steps plays in providing useful information for decision makers.
7. Explain how end-of-period adjustments help ensure that financial statements are fairly presented and describe typical types of adjustments.

 Every organization must have an accounting system to generate information needed by decision makers .
 The size, complexity, and type of entity all influence the kinds of decisions that need to be made and therefore the way in which information is accumulated and reported in the financial statements.

Assets = Liabilities + Owners’ Equity
Can be expanded by detailing the individual asset, liability, and equity elements. For example, a small store might appear as follows:
ASSETS = LIABILITIES + O. EQUITY cash + accounts + inventory = accounts + other receivable
+ capital + retained payable payables stock earnings

 Decision makers are interested in the individual elements of financial statements.
 Information about individual financial statement elements is accumulated in ledger accounts .
 The list of all accounts is referred to as the chart of accounts , and each account is assigned both a title and a number.

Information for an individual asset, liability, or owners’ equity item is accumulated in an account , which can be represented simply as follows:
Cash
This form of ledger account is known as a T-account and is useful for explanatory purposes. For a given account, all increases are recorded on one side, and all decreases on the other side. The account balance is the difference between total increases and total decreases in the account.

Exhibit 7-2
Each balance sheet element is included in the accounting equation, and a T-account can be used for each one.
ASSETS = LIABILITIES + OWNERS’ EQUITY
Cash
12,000
Inventory
+
28,000
=
Accounts
Payable
7,000
+
Common
Stock
30,000
+
Retained
Earnings
3,000

The accounting profession uses the term debit to mean (1) the left side of an account , (2) an entry or amount on the left side , (3) the act of making an entry to the left side of an account, and the term credit to mean the same for the right side of an account .
ANY ACCOUNT
DEBIT CREDIT

Because assets are on the left side of the accounting equation, asset accounts are increased on the left side of the account (with a debit). Liabilities and owners’ equity are on the right side of the equation and are increased on the right side of the account
(with a credit).
Assets
=
Liabilities and
Owners’ Equity
(debit) increase
(credit) decrease
(debit) decrease
(credit) increase

If this is true,
Assets
(debit) increase
(credit) decrease
=
Liabilities and
Owners’ Equity
(debit) decrease
(credit) increase then the terms debit and credit reflect the following changes in an account:
Debits (dr.) - increase assets Credits (cr.) - decrease assets
- decrease liabilities
- decrease equities
- increase liabilities
- increase equities

 Double-entry bookkeeping is based on the accounting equation. The following characteristics must exist:
– each recorded event must have at least 2 effects
– debits must always equal the credits for both individual transactions, and the sum of all account balances
– the equality rule ensures that information is processed accurately and completely

Exhibit 7-3
(partial)
If . . .
Then one or More of the
Following Must Occur
An asset increases
An asset decreases
- Another asset decreases
- A liability increases
- Equity increases
- Another asset increases
- A liability decreases
- Equity decreases

Exhibit 7-3
(partial)
If . . .
Then one or More of the
Following Must Occur
A liability increases
A liability decreases
- Another liability decreases
- Equity decreases
- An asset increases
- Another liability increases
- Equity increases
- An asset decreases

Exhibit 7-3
(partial)
If . . .
An ownership claim increases
An ownership claim decreases
Then one or More of the
Following Must Occur
- Another ownership claim decreases
- A liability decreases
- An asset increases
- Another ownership claim increases
- A liability increases
- An asset decreases

Accounting records of all entities contain two major types of accounts:
1) Permanent accounts --are reported in the balance sheet and relate to the financial position of the entity. These account balances carry forward from period to period.
2) Temporary accounts --are reported in the income statement or retained earnings statement and relate to activities during a period. These account balances are carried only for one period.

Exhibit 7-4
Type of Account
Permanent
Statement
Element
Assets
Normal
Balance
Debit
Liabilities Credit
Owners' Equity Credit
Reported On
Balance sheet
Balance sheet
Balance sheet
Temporary (All are Revenues
equity accounts and Expenses
are closed to Retained Gains
Earnings) Losses
Dividends
Credit
Debit
Credit
Debit
Debit
Income statement
Income statement
Income statement
Income statement
Retained earnings statement

Elements of owners’ equity are crucial to understanding a company’s activities. Owners’ equity may be expanded as follows:
Assets = Liabilities + Owners’ Equity
Assets = Liabilities + Capital Stock + Retained Earnings
Assets = Liabilities + Capital Stock + Beginning Retained
Earnings + Revenues - Expenses - Dividends
The last equation ties together the income statement
(revenues, expenses), retained earnings statement (net income, dividends), and balance sheet (retained earnings).

The accounting cycle is the entire series of steps needed to record, accumulate, process, and report financial information.
The eight steps are:
1) Occurrence of a transaction
2) Analysis of transaction
3) Recording of transaction
4) Posting to ledger accounts
5) Preparation of trial balance
6) Adjustment of balances
7) Preparation of financial statements
8) Closing of temporary accounts

1) Occurrence of transactions --Economic events requiring recognition according to the criteria discussed in chapter 4 are evidenced by source documents such as sales receipts and invoices.
2) Analysis of transactions --Based upon the evidence available, the transaction or event is classified and measured in order to know which accounts are affected and by how much.

3) Recording of transactions --Upon analysis, the transaction is recorded in a journal, which provides a chronological record of an entity’s activities. The journal entry includes the date, titles and numbers of accounts affected, and the specific debit or credit dollar amounts.
4) Posting to ledger accounts --Each amount in the journal is transferred to the appropriate ledger account. The entire set of accounts is known as the general ledger.

5) Preparation of trial balance --A list of all accounts and their balances is prepared to ensure the accuracy of the recording and posting processes by making sure the sum of debit balances equals the sum of credit balances.
6) Adjustment of balances --All account balances must be examined prior to preparation of financial statements, and updated as needed through adjusting journal entries posted to the ledger.

7) Preparation of financial statements --The financial statements are prepared from the account balances determined after adjusting entries (the adjusted trial balance).
8) Closing of temporary accounts --All temporary account balances are transferred to retained earnings via closing entries, leaving all temporary account balances at zero. Closing entries must be journalized and posted to the ledger and a post-closing trial balance is prepared.

Exhibit 7-5
Closing of temporary accounts
Stockholders’
Equity
Cash Flow
Balance
Sheet
Income
Statement
$
Occurrence of transaction
Trial Balance
Dr. Cr .
Preparation of financial statements
Adjustment of balances
Preparation of trial balance
Invoice
Sales costs
Analysis of transaction
Journal
Recording of transaction
Posting to ledger account

Adjustments: The Matching Concept at Work
End-of-period adjustments are needed because recording all events that affect a company when they occur is not costeffective, such as interest on a bank loan that accrues daily.
Accountants make five types of adjusting entries:
1) Accrued income
2) Accrued expense
3) Unearned income
4) Prepaid expenses
5) Depreciation of assets
Adjustment of balances

Adjustment of balances
Income should be reported in the period in which it is earned.
Some types of income, such as interest, grow over time rather than occur at a point in time and are therefore said to accrue . Interest earned on a Note Receivable by year-end of $1,225 would be recorded as follows:
Dr. Cr.
Interest Receivable $1,225
Interest Income $1,225
The receivable will appear as a current asset on the balance sheet, and the income on the income statement.

Adjustment of balances
The matching concept requires expenses (expired costs) to be reported in the period in which the related benefits are received, regardless of cash flow. Expenses that grow over time and are paid after the related benefits are received are called accrued expenses . If weekly payroll (paid on
Fridays) is $100,000 and year-end is on Tuesday, two days of accrued wages expense and liability must be recognized as follows:
Dr. Cr.
Wages expense $40,000
Wages payable $40,000

Adjustment of balances
Cash receipts for income before the monies are earned must be recognized as unearned income , a liability. At year-end, the portion of monies received in advance that has been earned must be recognized as income . If our tenant prepaid 12 months of rent for $18,000 on October
1 and we recognized that as Unearned Rent , then on
December 31 (year-end), Rental Income must be recognized as follows:
Dr. Cr.
Unearned rental income
Rental income
$ 4,500
$4,500

Adjustment of balances
Some types of operating costs are paid in advance of the period(s) in which they provide benefits and are known as prepaid expenses (assets) until expired, when they become expenses . If insurance for $3,600 is purchased for one-year of coverage on September 1, at December
31 (year-end), the following recognition of expired insurance cost is as follows:
Dr. Cr.
Insurance expense $1,200
Prepaid insurance $ 1,200

Adjustment of balances
Long-lived operating assets such as equipment are used to generate revenues over a number of periods. A portion of their cost must be recognized as expense in the periods benefitted. Equipment purchased for $80,000 that will benefit the entity for 5 years, would require
$16,000 of annual depreciation expense as follows:
Dr. Cr.
Depreciation expense
Accumulated depreciation
$16,000
$ 16,000
Accumulated depreciation is a contra-asset account that would offset the Equipment account in the balance sheet.

To clarify, adjustments aren’t corrections of errors made, but are cost-effective means of adjusting the accounts to bring them up to date before financial statements are prepared.
Note that each adjusting entry affects at least one temporary and at least one permanent account ; in other words, each entry updates both the balance sheet and the income statement.

Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States
Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.