Accounting Information System | Journal, Ledger Accounts, and Trial Balance | Cash-Basis Versus Accrual-Basis
Accounting | Accrual Accounting Concepts | Adjusting Entries, Adjusted Trial Balance, and Closing |
After learning about the income statement and the balance sheet in Chapters 1 and 2, we are now being introduced
to the accounting cycle and certain underlying accounting concepts that influence the contents of those two
financial statements.

Accounting Information System Just what, exactly, is the accounting information system? Is it a room full of
computers and papers? Not necessarily. The accounting information system consists of data, papers to support the
data, machines to process the data, and most importantly, people to report the resulting information to those who
make decisions based on such information. Every organization that is engaged in transactions needs an accounting
information system. This brings us to an important term used in accounting—a transaction! But what, exactly, is a

Identifying Business Transactions

A transaction is any event that involves an exchange or consumption of resources. A transaction could take place
between a company and external parties (e.g., purchase of raw materials from suppliers or sale of merchandise to
customers), or within a company itself (e.g., a company uses supplies that were purchased at a previous date and
were held as an asset called Supplies until the date of use). Both events are recordable in the books of the
A Transaction Is an Economic Event
A transaction is an economic event that alters the financial position of the entities engaging in it. For example,
when a company purchases a machine (or uses the services of another business) either by using its cash or on
credit, it acquires a new item (or incurs an expense) and simultaneously depletes its cash or incurs a liability.
That is a transaction! Simply placing an order with a vendor or hiring an employee is not recorded as a
Every transaction has an impact on the accounting equation of the company. If you recall from Week 1, the
accounting equation is what keeps a balance sheet balanced. The equation looks like this:


Accounting is transaction-based, so whenever an event occurs, we analyze its impact on the accounting equation and
record it accordingly in the books of accounts. Some examples of such events are:
1. A group of people (stockholders) invests $100,000 in a company. This will cause cash to increase ASSETS on
the left side of the equation, and common stock capital will increase EQUITY on the right side of the equation.
After this transaction is recorded, the accounting equation is still in balance.
2. The company purchases office equipment for $10,000. At the time of purchase, $5,000 cash is paid in a down
payment and the balance is payable after 90 days. ASSETS on the left side of the equation increase by $10,000 in
the form of the equipment and decrease by $5,000 in the form of cash. This results in a NET increase of $5,000 on
the left side of the equation, which then is balanced by an increase of $5,000 in accounts payable (or notes
payable) LIABILITIES on the right side. Thus, a transaction may affect more than one account on each or either
side of the equation.
3. The company hires a CEO who will be making $300,000 per year. In this case, there is no transaction on the
date of the hiring, because there has been no exchange of resources or services. Nothing will be recorded in the
books until the CEO has performed services.
What is described above is referred to as a transaction analysis, and it will look like this:
Cash + Office Equip = LIABILITIES
Accounts/Notes Payable + STOCKHOLDERS’ EQUITY
Common Stock
(1) +100,00 +100,000
(2) -5,000 + 10,000 +5,000
(3) Not an accounting transaction

Illustration 3-3 on page 110 of your textbook is a good example of how different transactions affect the
accounting equation.

Now we have to find a way to record transactions in the books. This is where the accounting information system
starts functioning. All transactions are first recorded in the journal and then posted (transferred) to the
appropriate accounts in the ledger. An account is a summary of transactions pertaining to any item, wherein the
item could be an asset (e.g., cash), liability (e.g., amounts due to suppliers), revenue (e.g., sales), expense
(e.g., salaries to employees), or owners’ equity (e.g., capital stock). A collection of all accounts in one place
is called a ledger. Transactions are entered into the journal and posted to the ledger by following certain rules.

Rules of Debit and Credit
1. Accounts on the left side of the accounting equation (to the left of the “=” sign) are increased by debits
(abbreviation DR) and decreased by credits (abbreviation CR).
2. Accounts on the right side of the accounting equation are increased by credits and decreased by debits.
The words debit and credit do not have any special meaning other than what is described above. Remember that these
are just tools for recording information in the books of accounts.

Increases and decreases in assets and liabilities are easy to follow.

As for owners’ equity:
• Equity increases because of either of two reasons:
o Whenever the owners make additional investments of resources into the business
o The business earns revenues
• Further, equity decreases because of either of two reasons:
o Whenever the owners withdraw resources from the business (e.g., in the form of dividends paid to
stockholders, or in the case of a single-owner business when the owner withdraws cash from the business)
o The business incurs an expense
Remember the interrelationships of the financial statements from Illustration 1-9 on page 17?

Net income (i.e., revenues–expenses) from the income statement flows to the retained earnings statement and then
into owners’ equity. Therefore, (revenue–expenses) it is shown under the stockholders’ equity section of the
accounting equation.
Stockholders’ Equity
Common Stock + Retained Earnings + (Revenue–Expenses) – Dividends
Algebra Review


Rules of Debt and Credit

Rules of Debit and Credit

This Drag-and-Drop activity provides you with an opportunity to practice rules of debit and credit with regards to
different accounts.
Therefore, the accounting equation may be written as:
Assets = Liabilities + [Common Stock + Retained Earnings + (Revenue – Expenses) – Dividends]

Revenues increase stockholders’ equity via retained earnings. Retained earnings have a credit balance, so revenues
are increased by credits. Expenses decrease stockholders’ equity via retained earnings, which means expenses are
increased by debits.

Illustration 3-16 on page 116 of your textbook nicely summarizes the rules of debit and credit for different
categories of the items in the financial statements. It will be a good idea to refer to that illustration from
time to time until you memorize the rules.

Journal, Ledger Accounts, and Trial Balance Every transaction is first entered into a journal and then
transferred or posted to the appropriate accounts affected by the transaction.
Journal Entry

For a transaction involving the Balance Sheet accounts, we can record the changes using a three-step process.
Click the picture to view an interactive demo. (Note: this tutorial requires sound.)
Journal Entry
You may ask, why record the information in two places, namely, once in the journal and then again in the ledger? A
journal keeps a chronological record of business transactions as those transactions happen, so you always know
which transactions took place on a given day. However, if you want to know the information about a specific item,
such as how much rent was paid during the year or how much interest was received during the quarter, you cannot
get that information from the journal. For that, you have to look at the rent expense account or interest revenue
account in the ledger, where the information is sorted and posted to the specific accounts.
For the accounting information to be eventually reported in the financial statements, we have to know the total
amount under each specific asset, liability, revenue, expense, and owners’ equity item. Here we are talking about
finding the balance of each account! The balance in each account is found by comparing the total of its debit side
with the total of its credit side. If the debit side total is greater than the credit side total, we say that the
account has a debit balance. If the credit side total is greater than the debit side total, we say that the
account has a credit balance.

Normal Balance of an Account
The normal balance of an account is influenced by whether we debit or credit that account for the increase in the
account. Thus, an asset account has a normal debit balance, but a liability account has a normal credit balance.
A trial balance is a listing of all accounts and their balances at the end of a period. The preparation of a trial
balance is the starting point in the process to prepare the financial statements, and therefore a trial balance
may be prepared monthly, quarterly, or annually, depending on how often the company prepares its financial
The trial balance shows that the total of the debit amounts equals the total of the credit amounts, but it does
not ensure that all transactions have been recorded or that all transactions have been recorded correctly. For
example, rent expense could have been debited (instead of utility expense) when the utility bill was paid. In this
case, the trial balance would be in balance, but the utility expense figure would be understated for the period,
and rent expense would be overstated for the period. Also, a sale of merchandise may have been recorded two times
or may not have been recorded at all. Yet, it will not affect the trial balance total. That’s why we need more
checks and balances within the company to ensure that such errors and omissions are detected and corrected on a
timely basis.

Please note the order of the accounts on the trial balance. The balance sheet accounts of assets, liabilities, and
stockholders’ equity are listed first, and then the income statement accounts of revenue and expense are listed.

Cash-Basis Versus Accrual-Basis Accounting Some businesses follow the cash-basis accounting approach, in
which revenue is recorded only when it is received in cash, and an expense is recorded only when it is paid in
cash. Under this approach, there are no receivables or payables in the accounts. Most small businesses may follow
this approach. Large and publicly traded companies, however, cannot follow this approach because it is not in
conformity with the generally accepted accounting principles (remember, you heard this term in Week 1!). Publicly
traded companies have to follow the accrual-basis accounting approach.

Under accrual accounting, revenue is recorded when it is earned, regardless of the timing of its receipt, and an
expense is recorded when it is incurred, regardless of when it is paid. The accrual-basis approach records
revenues and expenses based on the happening of those events, independent of when cash comes in or goes out.

Though smaller, private businesses are not required to use accrual-basis accounting, they still may choose to use
it under certain circumstances. Can you guess when that might happen? We will discuss this in the Discussion area.

Accrual Accounting Concepts Revenue Recognition Principle

According to this principle, revenue is recognized (recorded in the books) when it is earned, and revenue is
earned when there is an exchange of goods, or the performance of services is complete or virtually complete. For
example, if you have a furniture-making business in which you sell on credit, you can record revenue when you make
and ship the furniture to your customers, even if they will not pay until after 30 days or so from the time of the
shipment. Also, if you are in the business of painting houses, you earn your revenue when you finish painting a
house. You can record the revenue even if you have not formally sent an invoice to the customer, as long as you
have finished the work and the customer has approved it. Note that, in this case, the revenue is realizable
because you have a promise from your customer that he or she will honor your invoice in return for the goods or
services that they have accepted from you. Of course, you may not record the revenue if there is a significant
doubt about whether you will be able to collect the money from the customer after providing them goods or
services. This could happen if, right after painting a customer’s house, the house is burned down and the customer
has no money to pay.

Revenue recognition is a very important area and has been a subject of discussion in recent years. Can you guess
why? According to a study sponsored by the U.S. Government Accountability Office, a large number of companies have
ended up restating their financial statements in the past few years because of making “mistakes” in recording
revenue. Have you read about companies that allegedly made errors in recording their yearly revenues? If so,
please remember to bring that up at the right time when we discuss it in the Discussion area this week.

Matching Principle

Another important accounting principle that has a profound impact on the income statement of a company is the
matching principle. According to this principle, in order to calculate the net income correctly, expenses should
be matched with those revenues that are deemed to result from the incurring of those expenses. Thus, when
calculating the net income, cost of goods sold is subtracted from sales, and sales commission is subtracted as an
expense from sales, and so forth.

However, sometimes such direct matching is not possible. In that situation, expenses are matched with the revenues
of the period in which those expenses are incurred. For example, expenses like salaries of administrative
employees, depreciation on office equipment and building(s), and income tax cannot be associated directly with any
specific revenues. Hence such expenses are reported on the income statement of the period in which these expenses
are incurred.

Time Period Assumption

If you started a business with $100,000 in 1988 and closed the business at the end of 2008 with the owners’ equity
showing a balance of $150,000,000, then the total income of the business over its life would be $150,000,000 –
$100,000 = $149,900,000. However, if your business is also co-owned by other people (e.g., stockholders), they are
not going to wait for 20 years to find out if their investments made a profit or were a loss for them. It is a
common practice, therefore, to divide the life of a business into 12 monthly periods, called the accounting year,
and prepare financial statements for each such accounting year. Publicly traded companies are required to publish
their financial results every quarter, in addition to publishing their annual financial statements. Because it is
important to know how your business is doing on a continual basis, most public and many private companies prepare
their financial statements on a monthly basis for their internal uses.

Adjusting Entries, Adjusted Trial Balance, and Closing Adjusting Entries

A direct result of using the accrual-basis approach to accounting is that whenever we are ready to prepare
financial statements, we have to make adjusting entries in the books so that all assets, liabilities, revenues,
and expenses reflect their most up-to-date amounts.

Note that accrual accounting requires us to record revenue when it is earned (regardless of when it is received)
and record an expense when it is incurred (regardless of when it is paid). Thus, under accrual accounting, there
comes a time when we record revenue and in the absence of a simultaneous cash receipt, also record a receivable
(an asset). Likewise, there may be a time when we record an expense and in the absence of a simultaneous cash
payment, also record a payable (a liability). In addition, there are times when a business may receive money in
advance of earning it (e.g., receiving subscriptions from customers before delivering magazines) or pay expenses
before incurring them (e.g., prepaying insurance premium or rent several months in advance), thus creating
unearned revenues (a liability) or prepaid expenses (an asset). If, around the time of the preparation of the
financial statements, circumstances indicate that there may be some unrecorded revenues or expenses or unearned
revenues and prepaid expenses, we have to employ adjusting entries to record such revenues and expenses and adjust
the corresponding assets and liabilities. Not making such adjusting entries on a timely basis misstates revenues
and expenses, and affects net income for the period.

Illustrations 4-3 on page 168 and Illustration 4-23 on page 181 together provide good summaries of the four types
of adjusting entries that may be found in any company’s books. It should be noted that it may not be necessary to
make each of the four types of adjusting entries in every accounting period. The choice of the entry depends on
the circumstances of each case. For example, if there are no prepaid expenses in a period, there is no need to
make an entry for showing the expiration of the prepayment.
Points to Remember About Adjusting Entries
An adjusting entry is made because a revenue or expense is being recorded without a simultaneous cash receipt or
payment or to show the expiration of an advance receipt or prepayment of a revenue or expense, respectively. Thus,
at the time of an adjusting entry, there is no exchange of cash.

Also, every adjusting entry involves one revenue or expense, and one asset or liability.
For additional information regarding adjusting journal entries, please review the tutorial below:
Adjusting Entries Tutorial
One of the key advantages of an accounting information system is the automated nature of the financial statements.
Because the financial statements are adjusted with every journal entry and every change in the chart of accounts,
it is easy to see how the entries that you make impact the statements. At the same time, the financial statements
are intimately interconnected. When one changes, the others change as well. A lot of students really like learning
Peachtree for this reason. They begin to see how all of the different parts of an accounting system fit together.

Click on the link below to open the tutorial, and click the buttons in the tutorial to learn more about adjusting
entries. Adjusting Entries
Adjusted Trial Balance

After the adjusting entries are posted to the appropriate ledger accounts, all accounts are balanced, and once
again a revised trial balance, called an adjusted trial balance, is prepared. This adjusted trial balance becomes
the source of information for preparing the income statement and balance sheet

Closing Entries and the Closing Process

The revenue accounts, expense accounts, and dividend accounts are called temporary accounts because these exist
only to arrive at the net income figure for the year and update the retained earnings balance, which then is
merged into owners’ equity. Once the financial statements have been prepared, closing entries are made and posted
to close the temporary accounts. At that point, all revenues, expenses, and dividend accounts show zero balances.
Thus we begin each new year with zero amounts in revenues, expenses, and dividends. Then the post-closing trial
balance is prepared. On the post-closing trial balance, you will find only the permanent accounts such as assets,
liabilities, and stockholders’ equity accounts (capital and retained earnings).
The rules of Revenue Recognition are similar under GAPP and IFRS. Revenue is recognized when it is both realized
and earned, but not necessarily when the cash is paid. The biggest difference is GAAP details when to recognize
revenue with specifics by revenue type and industry. This form of regulation is known as prescriptive rules. Under
IFRS, there are more general rules with a single standard and general principles and examples.

Self-Assessment Let’s see how much you learned from the information above. It’s time for the Self-Test. Click here
to find the Self-Tests. Click on Chapter 3 and complete the questions. When you are finished with Chapter 3, go on
to Chapter 4. You may take the Additional Self-Tests by clicking here. Again, you can complete Chapter 3, and then
proceed to Chapter 4.


The Accounting Cycle and Accrual Accounting Concepts