• ACCOUNT.

A systematic arrangement that shows the effect of transactions and other events on a
specific element (asset, liability, and so on). Companies keep a separate account for each asset,
liability, revenue, and expense, and for capital (stockholders’ equity). Because the format of an
account often resembles the letter T, it is sometimes referred to as a T-account.
• REAL AND NOMINAL ACCOUNTS. Real (permanent) accounts are asset, liability, and equity
accounts; they appear on the balance sheet. Nominal (temporary) accounts are revenue, expense,
and dividend accounts; except for dividends, they appear on the income statement. Companies
periodically close nominal accounts; they do not close real accounts.
• LEDGER. The book (or computer printouts) containing the accounts. A general ledger is a collection
of all the asset, liability, stockholders’ equity, revenue, and expense accounts.
• JOURNAL. The “book of original entry” where the company initially records transactions and selected
other events. Various amounts are transferred from the book of original entry, the journal, to the
ledger. Entering transaction data in the journal is known as journalizing.
• POSTING. The process of transferring the essential facts and figures from the book of original entry
to the ledger accounts.
• TRIAL BALANCE. The list of all open accounts in the ledger and their balances. The trial balance
taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial
balance taken immediately after closing entries have been posted is called a post-closing (or after-
closing) trial balance. Companies may prepare a trial balance at any time.
• ADJUSTING ENTRIES. Entries made at the end of an accounting period to bring all accounts up to
date on an accrual basis, so that the company can prepare correct financial statements.
• FINANCIAL STATEMENTS. Statements that reflect the collection, tabulation, and final
summarization of the accounting data. Four statements are involved. (1) The balance sheet shows
the financial condition of the enterprise at the end of a period. (2) The income statement measures
the results of operations during the period. (3) The statement of cash flows reports the cash
provided and used by operating, investing, and financing activities during the period. (4) The
statement of retained earnings reconciles the balance of the retained earnings account from the
beginning to the end of the period.
• CLOSING ENTRIES. The formal process by which the enterprise reduces all nominal accounts to
zero and determines and transfers the net income or net loss to a stockholders ‘equity account. Also
known as “closing the ledger,” “closing the books,” or merely “closing.”

Describe how accounts, debits, and credits are used to record business transactions.
The Account
An account (general ledger) is an individual accounting record of increases and decreases in a specific
asset, liability, or owner’s equity item. For example, Softbyte Co. would have separate accounts for

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Cash, Accounts Receivable, Accounts Payable, Service Revenue, Salaries and Wages Expense, and so
on. (Note that whenever we are referring to a specific account, we capitalize the name.) In its simplest
form, an account consists of three parts: (1) a title, (2) a left or debit side, and (3) a right or credit side.
Because the format of an account resembles the letter T, we refer to it as a T-account. The Illustration
shows the basic form of an account.

Debits and Credits

The terms debit (Dr.) and credit (Cr.) mean left
and right, respectively. These terms do not mean
increase or decrease, but instead describe where
a company makes entries in the recording
process. That is, when a company enters an
amount on the left side of an account, it debits
the account. When it makes an entry on the right side, it credits the account. When comparing the totals
of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits.
An account shows a credit balance if the credit amounts exceed the debits. The positioning of debits on
the left and credits on the right is simply an accounting custom. We could function just as well if we
reversed the sides. However, the United States adopted the custom, now the rule, of having debits on
the left side of an account and credits on the right side, similar to the custom of driving on the right-hand
side of the road. This rule applies to all accounts. The equality of debits and credits provides the basis
for the double-entry system of recording transactions (sometimes referred to as double-entry
bookkeeping). Under the universally used double-entry accounting system, a company records the
dual (two-sided) effect of each transaction in appropriate accounts. This system provides a logical
method for recording transactions. It also offers a means of proving the accuracy of the recorded
amounts. If a company records every transaction with equal debits and credits, then the sum of all the
debits to the accounts must equal the sum
of all the credits.

State the accounting equation, and

define its components.
The two basic elements of a business are
what it owns and what it owes. Assets are
the resources a business owns. Liabilities
and owner’s equity are the rights or claims
against these resources. Claims of those to
whom the company owes money (creditors)

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are called liabilities. Claims of owners are called owner’s equity. We can express the relationship of
assets, liabilities, and owner’s equity as an equation, as shown in Illustration.

This relationship is the basic accounting equation. Assets must equal the sum of liabilities and
owner’s equity. Liabilities appear before owner’s equity in the basic accounting equation because they
are paid first if a business is liquidated. The accounting equation applies to all economic entities
regardless of size, nature of business, or form of business organization. It applies to a small
proprietorship such as a corner grocery store as well as to a giant corporation such as PepsiCo. The
equation provides the underlying framework for recording and summarizing economic events. Let’s
look in more detail at the categories in the basic accounting equation.

Increases in Owners’ Equity

In a proprietorship, owner’s investments and revenues increase owner’s equity.
INVESTMENTS BY OWNER are the assets the owner puts into the business. These investments
increase owner’s equity. They are recorded in a category called owner’s capital.
REVENUES are the gross increase in owner’s equity resulting from business activities entered
into for the purpose of earning income. Generally, revenues result from selling merchandise,
performing services, renting property, and lending money. Common sources of revenue are sales, fees,
services, commissions, interest, dividends, royalties, and rent. Revenues usually result in an increase in
an asset. They may arise from different sources and are called various names depending on the nature
of the business. Campus Pizza, for instance, has two categories of sales revenues—pizza sales and
beverage sales.

Decreases in Owners’ Equity

In a proprietorship, owner’s drawings and expenses decrease owner’s equity.
DRAWINGS An owner may withdraw cash or other assets for personal use. We use a separate
classification called drawings to determine the total withdrawals for each accounting period. Drawings
decrease owner’s equity. They are recorded in a category called owner’s drawings.
EXPENSES are the cost of assets consumed or services used in the process of earning revenue. They
are decreases in owner’s equity that result from operating the business. For example, salaries and
wages expense; utilities expense (electric, gas, and water expense); delivery expense (gasoline, repairs,
licenses, etc.); rent expense; interest expense; and property tax expense.
In summary, owner’s equity is increased by an owner’s investments and by revenues from business
operations. Owner’s equity is decreased by an owner’s withdrawals of assets and by expenses.

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Illustration expands the basic accounting equation by showing the items that comprise owner’s equity.
This format is referred to as the expanded accounting equation.

Corporate Capital
Owners’ equity is identified by various names: stockholders’ equity, shareholders’ equity, or
corporate capital. The stockholders’ equity section of a corporation’s balance sheet consists of two
parts: (1) paid-in (contributed) capital and (2) retained earnings (earned capital). The distinction between
paid-in capital and retained earnings is important from both a legal and a financial point of view.
Legally, corporations can make distributions of earnings (declare dividends) out of retained earnings in
all states (note that there are no drawings her).

Paid-In Capital
Paid-in capital is the total amount of cash and other assets paid in to the corporation by stockholders in
exchange for capital stock. When a corporation has only one class of stock, it is common stock.

Retained Earnings
Retained earnings is net income that a corporation retains for future use. Net income is recorded in
Retained Earnings by a closing entry that debits Income Summary and credits Retained Earnings. We
will talk about that in details later. Illustration expands the basic accounting equation by showing the
items that comprise shareholders’ equity (Corporate Capital).

Analyze the Effects of Business Transactions on the Accounting Equation

Every time a transaction occurs, the elements of the accounting equation change.
However, the basic equality remains. To illustrate, consider the following eight different transactions for
Perez Inc.
1. Owners invest $40,000 in exchange for common stock.

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2. Disburse $600 cash for administrative wages.

3. Purchase office equipment priced at $5,200, giving a 10 percent promissory note in exchange.

4. Receive $4,000 cash for services performed.

5. Pay off a short-term liability of $7,000.

6. Declare a cash dividend of $5,000.

7. Convert a long-term liability of $80,000 into common stock.

8. Pay cash of $16,000 for a delivery van.

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