McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Three The Double- Entry Accounting System

3-2 Learning Objective 1 Explain the fundamental concepts associated with double-entry accounting systems.

3-3 Debit/Credit Terminology T-account Debit Credit Account Title

3-4 Debits and Credits Debit = LeftCredit = Right increase debit decrease credit Asset accounts increase on the left or debit side and decrease on the right or credit side. increase creditdecrease debit Liability accounts increase on the right or credit side and decrease on the left or debit side. increase credit decrease debit Equity accounts increase on the right or credit side and decrease on the left or debit side. In every transaction, the total dollar value of all debits equals the total dollar value of all credits.

3-5 Learning Objective 2 Describe business events using debit/credit terminology.

3-6 Double-Entry Accounting Let’s see how debits and credits work by looking at transactions for Collins Consultants.

3-7 Event 1: Collins Consultants was established on January 1, 2007, when it acquired $25,000 cash from Collins. 1.Increase assets (cash). 2.Increase equity (common stock). Asset Source Transaction

3-8 Event 2: On February 17, Collins Consultants purchased $850 of office supplies on account from Morris Supply Company. 1.Increase assets (supplies). 2.Increase liabilities (accounts payable). Asset Source Transaction

3-9 Event 3: On February 28, Collins Consultants signed a contract to evaluate the internal control system used by Kendall Food Stores. Kendall paid Collins $5,000 in advance for these future services. 1.Increase assets (cash). 2.Increase liabilities (unearned revenue). Asset Source Transaction

3-10 Event 4: On March 1, Collins Consultants received $18,000 from signing a contract to provide professional advice to Harwood Corporation over a one-year period. 1.Increase assets (cash). 2.Increase liabilities (unearned revenue). Asset Source Transaction

3-11 Event 5: On April 10, Collins Consultants provided $2,360 of services to Rex Company on account. 1.Increase assets (accounts receivable). 2.Increase equity (consulting revenue). Asset Source Transaction

3-12 Event 6: On April 29, Collins Consultants performed services and received $8,400 cash. 1.Increase assets (cash). 2.Increase equity (consulting revenue). Asset Source Transaction

3-13 Event 7: On June 30, Collins purchased land for $42,000 cash. 1.Increase assets (office equipment). 2.Decrease assets (cash). Asset Exchange Transaction

3-14 Event 8: On July 31, Collins paid $3,600 cash in advance for a one-year lease to rent office space beginning August 1. 1.Increase assets (prepaid rent). 2.Decrease assets (cash). Asset Exchange Transaction

3-15 Event 9: On August 8, Collins Consultants collected $1,200 from Rex Company as partial payment of the accounts receivable (see Event 5). 1.Increase assets (cash). 2.Decrease assets (accounts receivable). Asset Exchange Transaction

3-16 Event 10: On September 4, Collins Consultants paid employees who worked for the company $7,500 in salaries. 1.Decrease assets (cash). 2.Decrease equity (salaries expense). Asset Use Transaction

3-17 Event 11: On September 20, Collins Consultants paid a $1,500 cash dividend to its owner. 1.Decrease assets (cash). 2.Decrease equity (dividends). Asset Use Transaction

3-18 Event 12: On October 10, Collins Consultants paid Morris Supply Company the $850 owed from purchasing office supplies on account (see Event 2). 1.Decrease assets (cash). 2.Decrease liabilities (accounts payable). Asset Use Transaction

3-19 Event 13: On November 15, Collins completed its consulting evaluation of the internal control system used by Kendall Food Stores (see Event 3). 1.Decrease liabilities (unearned revenue). 2.Increase equity (consulting revenue). Claims Exchange Transaction

3-20 Event 14: On December 18, Collins Consultants received a $900 bill from Creative Ads for advertisements which had appeared in regional magazines. Collins plans to pay the bill later. 1.Increase liabilities (accounts payable). 2.Decrease equity (advertising expense). Claims Exchange Transaction

3-21 Learning Objective 4 Identify the events that need adjusting entries and record them.

3-22 Adjustment 1: Collins Consultants recognized $800 of accrued but unpaid salaries. 1.Increase liabilities (salaries payable). 2.Decrease equity (salaries expense). Claims Exchange Transaction

3-23 Adjustment 2: Collins Consultants recognized rent expense for the portion of prepaid rent used up since entering the lease agreement on July 31 (see Event 8). 1.Decrease assets (prepaid rent). 2.Decrease equity (rent expense). Asset Use Transaction

3-24 Adjustment 3: A physical count at the end of the year indicates that $125 worth of the supplies purchased on February 17 are still on hand (see Event 2). 1.Decrease assets (supplies). 2.Decrease equity (supplies expense). Asset Use Transaction

3-25 Adjustment 4: Collins Consultants adjusted its accounting records to reflect revenue earned to date on the contract to provide services to Harwood Corporation for a one-year period beginning March 1 (see Event 4). 1.Decrease liabilities (unearned revenue). 2.Increase equity (consulting revenue). Claims Exchange Transaction

3-26 Overview of Debit/Credit Relationships

3-27

3-28 Learning Objective 5 Record transactions using the general journal format.

3-29 The General Journal Accountants initially record data from source documents into a journal. Special Journals General Journals

3-30

3-31 Learning Objective 6 Prepare and interpret a trial balance.

3-32 Adjusted Trial Balance

3-33 Income Statement

3-34 Statement of Changes in Stockholders’ Equity

3-35 Balance Sheet

3-36 Statement of Cash Flows

3-37 Learning Objective 7 State the need for and record closing entries.

3-38 The Closing Process Let’s look at the closing entries for Collins Consultants. Establishes zero balances in all revenue, expense, and dividend accounts.

3-39 Closing Entries

3-40 Post-closing Trial Balance

3-41 Learning Objective 8 Analyze financial statements and make meaningful comparisons between companies by using a debt to assets ratio, a return on assets ratio, and a return on equity ratio.

3-42 Return on Assets Ratio Net Income Total Assets Evaluating performance requires considering the size of the investment base used to produce the income. This ratio measures the relationship between the level of income and the size of the investment. A larger ratio means the company did a better job of managing its assets.

3-43 Debt to Assets Ratio Total Debt Total Assets Borrowing money is risky business. This ratio helps evaluate the level of debt risk. A smaller ratio indicates that there is less debt risk for the company.

3-44 Return on Equity Ratio Net Income Stockholders’ Equity Owners are interested in this ratio to determine their return on their investment in the company. A larger ratio indicates that the owners have a higher return on their investment.

3-45 Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Creditors prefer less debt and more equity because equity represents a buffer of protection. Stockholders vs. Creditors

3-46 Real World Data

3-47 End of Chapter Three