From the event to the trial balance

The accounting cycle and this chapter

The accounting cycle is the sequence used to record a reporting period and prepare its financial statements:

1. Analyze transactions.
2. Record journal entries.
3. Post to ledger accounts.
4. Prepare the unadjusted trial balance.
5. Record adjusting entries.
6. Prepare the adjusted trial balance.
7. Prepare the financial statements.
8. Record closing entries.
9. Prepare the post-closing trial balance.

This chapter covers the first four steps. Chapter 2 covers adjustments and the adjusted trial balance. Chapter 3 covers the financial statements and closing entries.

In most organizations, software records and posts routine transactions. Accountants still need to understand this path so they can resolve unusual events, correct errors, and decide whether the resulting balances make sense.

Step 1: Analyze transactions

What counts as a transaction

Beacon Design is a corporation that creates logos and other design work for business clients. It also provides support after a project ends. Beacon's first year ends on December 31.

Like most organizations, Beacon does many things during a single year. It answers a request for proposal, disagrees with a client about a logo, interviews several designers and hires one, and wins an award. None of these activities is recorded in the accounting sense when it happens.

An accounting transaction is an event that changes an asset, a liability, or equity and has an amount the company can support. Hiring a designer does not create an entry by itself. After the designer works, Beacon can measure the wages it owes and record the expense and liability.

The examples in this chapter use six sets of events from Beacon's first year:

Each amount needs support. A bank record and stock agreement support the cash investment. Invoices, payment records, and the support contract support the other amounts.

The facts needed for each example appear beside the related analysis, entry, or ledger account.

The accounting equation

The accounting equation connects a company's resources with the claims on those resources:

An asset is a present right to an economic benefit. An economic benefit can help a company provide services, reduce costs, or receive cash. A liability is a present obligation to transfer an economic benefit. In these definitions, present means that the right or obligation exists on the date being reported. The related cash receipt, service, or payment can occur later.

Equity is the amount left for owners after liabilities are subtracted from assets. Revenue increases equity through the company's activities. Expenses reduce equity through those activities.

For the accounting-cycle work in this chapter, group accounts into five basic classes: assets, liabilities, equity, revenues, and expenses. These classes are enough to organize the transactions in this chapter, but they are not the FASB's complete set of financial statement elements. The FASB also identifies gains, losses, investments by owners, distributions to owners, and comprehensive income as separate elements. Chapter 4 covers the full set.

An account keeps the increases, decreases, and balance for one type of item. Cash and Equipment are separate asset accounts. Accounts Payable and Unearned Service Revenue are separate liability accounts. Separate accounts preserve details that a single asset or liability total would hide.

For an unfamiliar transaction, make four decisions:

1. Identify the event to record and its date.
2. Identify the accounts that changed and classify each account.
3. Determine whether each account increased or decreased.
4. Choose debit or credit and confirm that total debits equal total credits.

These decisions organize the analysis when the accounting is not obvious. You do not need to recite them for every routine transaction.

On January 2, Beacon's shareholders invest $40,000 cash and receive no-par common stock. Because the shares have no par value, Beacon records the full $40,000 in Common Stock. Cash, an asset, increases by $40,000. Common Stock, an equity account, also increases by $40,000. Assets and equity increase by the same amount.

Also on January 2, Beacon pays $18,000 cash for design equipment. Equipment increases by $18,000, and Cash decreases by $18,000. Beacon exchanged one asset for another, so total assets do not change. The purchase creates no liability and no immediate expense.

Compare the two January 2 events. The shareholder investment increases both sides of the equation: Cash increases on the asset side, and Common Stock increases within shareholders' equity. The equipment purchase changes two accounts on the asset side, Cash and Equipment, but does not change total assets. Beacon has converted one asset, Cash, into another asset, Equipment. Under double-entry accounting, every transaction has equal debits and credits. That equality keeps the accounting equation in balance after each entry.

Debits, credits, and normal balances

A debit is an amount on the left side of an account. A credit is an amount on the right. Debit does not mean decrease, and credit does not mean increase. The account class determines which side records an increase.

The normal balance is the side on which an account usually has its balance. An account that increases with debits usually has a debit balance. An account that increases with credits usually has a credit balance.

Beacon records wages as employees work. Each wage entry debits Wages Expense. If Beacon pays the wages at the same time, the entry credits Cash. If Beacon will pay later, it credits Wages Payable. The wage entries recorded through December 31 contain $62,000 of debit postings to Wages Expense:

The $62,000 is the unadjusted balance in Wages Expense. Chapter 2 records wages earned by December 31 that are not yet in the ledger. Chapter 3 shows how adjusted expense balances enter the income statement.

Step 2: Record journal entries

The journal records complete transactions by date. Each journal entry lists the debits first, indents the credited accounts, and has equal debit and credit amounts.

On April 1, Beacon pays $12,000 for insurance coverage from April 1 through March 31 of the next year. The payment gives Beacon the right to receive 12 months of coverage. It records that right as Prepaid Insurance:

One asset increased while another decreased, so total assets did not change. Beacon does not record the full amount as an expense on April 1 because none of the coverage has been used. Chapter 2 explains how Beacon records the coverage used by December 31.

On November 1, a client pays Beacon $6,000 for 6 months of support that Beacon will provide from November through April. Beacon receives Cash and takes on an obligation to provide the support:

The receipt increases both assets and liabilities by $6,000. Beacon records a liability because it still owes the client 6 months of support.

Step 3: Post to ledger accounts

The general ledger groups accounting activity by account. Every account, not only Cash, has its own ledger record. The journal shows complete entries in date order. The ledger shows all increases, decreases, and the ending balance for one account.

Posting copies each line of a journal entry to the named ledger account on the same side. Posting does not create a second transaction or change the entry.

Accountants often sketch a ledger account as a T-account. The account name is centered above the account, debits appear on the left, and credits appear on the right. The Cash account below contains the four cash transactions introduced earlier in this chapter:

This $16,000 is not Beacon's year-end Cash balance. The account above includes only those four cash transactions.

Now return to the November 1 customer advance. A client paid Beacon $6,000 for 6 months of support that Beacon had not yet provided. Beacon recorded this journal entry:

The debit remains a debit when it enters the Cash account. The credit remains a credit when it enters the Unearned Service Revenue account. The two postings reorganize one journal entry by account. They do not record another receipt or another $6,000.

Step 4: Prepare the unadjusted trial balance

The trial balance lists every ledger account and its ending balance. Debit balances appear in one column, credit balances appear in the other, and each column has a total.

Additional year-end information

The selected events above do not include every transaction from Beacon's first year. The complete ledger balances below also reflect customer collections, payments, borrowing, and other routine activity that the chapter has not shown.

Follow one transaction through the first four steps

The November 1 customer advance appears differently at each step.

The trial balance tests whether the debit balances and credit balances in the ledger add to the same total. It does not test whether Beacon recorded every transaction or chose the right date and accounts.

When the totals do not agree

The debit and credit totals should be equal. If they are not, the records contain at least one error that affected the columns by different amounts. The difference does not identify the error. Separate errors can also offset each other. Each error below usually makes the columns unequal:

Equal totals show only that the recorded debit balances and credit balances add to the same amount. They do not prove that all of the accounting is correct.

Errors that equal totals do not reveal

Equal totals do not show whether every transaction was recorded or whether the correct accounts were used. An error can remain hidden when it changes debits and credits by the same amount. These examples use Beacon, but the rule applies to every trial balance:

An entry can have equal debit and credit amounts and still record the wrong accounting. If the system were configured incorrectly, it could debit Cash and credit Service Revenue for $6,000. Beacon has not earned revenue because it has not provided the support. The contract shows that Beacon still owes the client 6 months of service, so Unearned Service Revenue is the correct credit.

Chapter 2 begins with another hidden error. Employees can work during the last week of December before Beacon receives the payroll report or pays them. If Beacon records nothing, the trial balance remains equal while Wages Expense and Wages Payable are too low.

From the event to the trial balance

The first four accounting-cycle steps create a traceable record. Analysis connects an event to its date and accounts. The journal keeps the complete entry together. The ledger groups the posted lines by account. The unadjusted trial balance lists the ending account balances and compares the debit and credit totals.

Every trial balance amount should be traceable through those records to the event and evidence behind it. Equal trial balance totals mean only that the recorded debit balances equal the recorded credit balances. They do not show that every transaction was recorded or that each entry uses the correct date, accounts, and amounts.

Software can move an incorrect entry through the journal and ledger without correcting it. The accountant must connect the entry to the evidence and decide whether the resulting balances reflect what happened.

Beacon's December 31 trial balance is unadjusted. In Chapter 2, Beacon records activity that the ledger does not yet reflect completely, including insurance Beacon has used, support it has provided, and wages it owes.