Chapter 03—The Accounting Cycle: Capturing Economic Events
Financial and Managerial Accounting, 18e 3-1
3 THE ACCOUNTING CYCLE: CAPTURING ECONOMIC EVENTS
Chapter Summary
Maintaining a set of accounting records is not optional for a business. The IRS requires
businesses to maintain records that can be audited. In addition, a business that does not maintain
adequate records will likely operate inefficiently.
The recording process lies at the foundation of the financial statements. This chapter
presents a comprehensive introduction to the accounting cycle. Coverage includes debit and
credit rules for both balance sheet and income statement accounts, recording transactions in the
journal and posting to the ledger, and the preparation of the trial balance.
In addition to the mechanical aspects of the accounting cycle, the student is also
confronted with several major concepts from accounting theory. Net income is introduced as an
increase in owner’s equity resulting from profitable operations. The nature of revenue and
expense is explored in detail as is the realization and matching principles underlying accrual
accounting.
The comprehensive coverage has resulted in a relatively lengthy chapter. However, use of
the continuing illustration of Overnight Auto is intended to allow for a reasonably efficient
presentation of this significant material. All of the transactions dealing with balance sheet
accounts are repeated from Chapter 2. Although the revenue and expense transactions are new to
this chapter, the exposure to the income statement and statement of cash flows in the previous
chapter should also shorten the time needed to cover recording such transactions.
Learning Objectives
1. Identify the steps in the accounting cycle and discuss the role of accounting records in an
organization.
2. Describe a ledger account and a ledger.
3. Understand how balance sheet accounts are increased or decreased.
4. Explain the double-entry system of accounting.
5. Explain the purpose of a journal and its relationship to the ledger.
6. Explain the nature of net income, revenue, and expenses.
7. Apply the realization and matching principles in recording revenue and expenses.
8. Understand how revenue and expense transactions are recorded in an accounting system.
9. Prepare a trial balance and explain its uses and limitations.
10. Distinguish between accounting cycle procedures and the knowledge of accounting.
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Brief Topical Outline
A. The accounting cycle
1. The role of accounting records
B. The ledger
C. The use of accounts
D. Debit and credit entries
1. Determining the balance of a T account
2. Debit balances in asset accounts
3. Credit balances in liability and owners’ equity accounts
4. Concise statement of the debit and credit rules
5. Double-entry accounting—the equality of debits and credits
E. The journal
1. Posting journal entries to the ledger accounts (and how to “read” a journal
entry)
F. Recording balance sheet transactions: an illustration (illustrated on pages 95–97)
G. Ledger accounts after posting (illustrated on page 98)
H. What is net income?
1. Retained earnings
2. The income statement: a preview—see Pathways Connection (page 101)
a. Income must be related to a specified period of time—see Case in Point
(page 102)
b. Accounting periods
3. Revenue
a. The realization principle: when to record revenue
4. Expenses
a. The matching principle: when to record expenses
b. Expenditures benefiting more than one accounting period—see
International Case in Point (page 104)
5. The accrual basis of accounting
6. Debit and credit rules for revenue and expenses
I. Dividends
J. Recording income statement transactions: an illustration (illustrated on pages 106–
111)—see Your Turn (page 110)
1. The journal
K. February’s ledger balances
L. The trial balance
1. Uses and limitations of the trial balance—see Ethics, Fraud, & Corporate
Governance (page 116)
M. Concluding remarks
1. The accounting cycle in perspective
Chapter 03—The Accounting Cycle: Capturing Economic Events
Financial and Managerial Accounting, 18e 3-3
Topical Coverage and Suggested Assignments
Class
Meetings on
Chapter
Topical
Outline
Coverage
Discussion
Questions*
Brief
Exercises*
Exercises*
Problems*
Critical
Thinking
Cases*
1
A – D
1, 4, 6, 7
1, 3, 4
1
2
E – G
10, 13, 14
5, 6, 7
2, 4, 7, 8, 11
1, 2, 3
1, 3
3
H – M
15
9, 10
12
4, 5
*Homework assignment (to be completed prior to class)
Comments and Observations
Teaching Objectives for Chapter 3
Our objectives in presenting this chapter are to:
1. Establish the usefulness of accounting records in organizations.
2. Explain and illustrate the purpose, unit of organization, and format of ledger accounts.
3. Relate the rules for debiting and crediting balance sheet accounts to the “side” of the balance
sheet on which the account appears.
4. Explain the double-entry system of accounting.
5. Explain and illustrate the purpose, unit of organization, and format of a general journal.
6. Explain the flow of financial information from the journal into the ledger accounts.
7. Explain the nature of net income, and define the terms revenue and expenses.
8. Illustrate the recording of revenue and expense transactions. Explain the debit and credit
rules for these transactions in the context of the effects upon owner’s equity.
9. Explain the realization principle and the matching principle, providing common examples.
Contrast accrual accounting with cash flows.
Chapter 03—The Accounting Cycle: Capturing Economic Events
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General Comments
Overnight Auto Service is used as a continuing example in Chapters 2 through 4. At the
outset in Chapter 3, the activities of the company are limited to balance sheet transactions. This
allows us to illustrate the mechanics of double-entry accounting and to show how changes in
assets, liabilities, and owners’ equity are recorded in accounting records before discussing the
more complicated concepts of revenue and expense. This approach also enables us to illustrate a
very simple “accounting cycle” — the “flow” of information from the initial recording of
transactions through the accounting records — without first having to cover adjusting entries and
closing entries.
Among the important concepts introduced in Chapter 3 is double-entry accounting.
Although double-entry accounting and the related rules of debit and credit may sound procedural
to some, we view the double-entry system as a truly ingenious device. Johann Goethe, the
renowned eighteenth-century German poet and novelist, described this system as “one of the
finest discoveries of the human intellect.” The great power of double-entry accounting is its
ability to record the components of profit and loss, that is, revenue and expenses, simultaneously
with the related changes in assets and liabilities. Thus, any accounting system that develops an
income statement as well as a balance sheet uses the principles of double entry.
In the first class meeting on Chapter 3, we introduce students to the uses of accounting
records in organizations. It is fairly obvious that accounting records will be used to record day–
to-day transactions and serve as the basis for developing financial statements, tax returns, and
other accounting reports. Less obvious to students are the other purposes of accounting records
including internal control and performance evaluation. Discussion Question 1 can be used as the
basis for class discussion of these uses of accounting information. We go on to introduce ledger
accounts as a vehicle for illustrating double-entry accounting. We stress the relationship between
the entry to record an increase in an account’s balance and the “side” of the balance sheet upon
which the account appears. This simple relationship is not only useful to students in learning the
rules of debits and credits, but is the very device that makes the double-entry system work.
In the first class meeting, we go on to introduce the general journal and focus upon the
“flow” of information through the accounting records and into the financial statements (balance
sheet). We stress the point that the journal and ledger contain the same information, differing
only as to the unit of organization. The journal is organized by transaction, whereas the same
data in the ledger is organized by financial statement item.
Our next overall objective in Chapter 3 is to show how business profits are defined and
measured in an accounting system. We emphasize the definitions of revenue and expenses and
the realization and matching principles. We find Exercise 7 useful in making the point that net
income is a change in owners’ equity, not a change in assets.
Careful attention should be given to both the realization principle and the matching
principle. These principles represent the basic difference between accrual accounting and cash
transactions. Also, these principles underlie many of the concepts that will be discussed in later
chapters. We introduce these principles during the first class meeting but discuss them again in
the second class meeting, illustrating the application of these principles in realistic business
situations. Cases 1 and 2 are intended for this purpose.
Chapter 03—The Accounting Cycle: Capturing Economic Events
Financial and Managerial Accounting, 18e 3-5
Supplemental Exercises
Group Exercise
Divide students into groups. Each group will explore two different accounting software
options by comparing and contrasting the features (as indicated on their respective websites),
examining the advantages and disadvantages, and making a recommendation between the two
based on their research. Each group will then present their findings to the class. Below are some
recommendations in terms of assigning software options to the groups:
Group 1: QuickBooks and Sage Peachtree
Group 2: SAP and Oracle
Group 3: NetSuite and Microsoft Dynamics
Group 4: PeopleSoft and Lawson
Internet Exercise
In Chapter 3 we have learned that net income is an increase in owners’ equity resulting
from profitable operations. Previously, Chapter 2 explained that when a business is organized as
a corporation, retained earnings represents the increase in stockholders’ equity that has
accumulated over the years as a result of profitable operations. Thus, net income for any one year
should explain a large part of the change in retained earnings from the beginning of the year to
for Apple. Scroll beneath the graph and click on the “Financials” link. Locate Net Income. Next,
click on the Balance Sheet link. Now compute the difference between retained (reinvested)
earnings at the beginning of the year and at the end. How closely does this approximate the net
income that you just computed?
Chapter 03—The Accounting Cycle: Capturing Economic Events
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CHAPTER 3 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
The account balances for Creative Band, Inc. as of May 31, 2017, are listed below in alphabetical order:
Accounts Payable ………………….. $12,000 Equipment …………………………. $18,000
Accounts Receivable ……………… $14,000 Land………………………………….. $52,000
Building………………………………… $42,000 Notes Payable ……………………. $30,000
Cash …………………………………….. $8,000 Capital Stock ……………………… $92,000
On June 3, Creative Band, Inc. collected $4,000 of its accounts receivable and paid $7,000 of its accounts
payable. In addition, 2,000 of additional shares of capital stock are issued for $5,600.
1 Refer to the above data. In a trial balance prepared on May 31, 2017, the sum of the debit column
is:
a $120,000.
b $156,000.
c $134,000.
d Some other amount.
2 Refer to the above data. On June 4, the balance in the Cash account is:
a $17,600.
b $ 5,000.
c $10,600.
d Some other amount.
3 Refer to the above data. On June 4, the balance in the Capital Stock account is:
a $86,400.
b $97,600.
c $94,000.
d Some other amount.
4 Refer to the above data. In a trial balance prepared on June 4, the sum of the credit column is:
a $130,000.
b $132,600.
c $127,000.
d Some other amount.
5 Refer to the above data. On June 6, the bookkeeper for Creative Band, Inc. makes this entry:
Equipment …………………………………………………………………………………………. 7,400
Cash ……………………………………………………………………………………… 4,200
Accounts Payable …………………………………………………………………… 3,200
This transaction:
a Decreases total assets.
b Involves the sale of equipment for $7,400.
c Increases total assets $7,400.
d Increases liabilities.
Chapter 03—The Accounting Cycle: Capturing Economic Events
Financial and Managerial Accounting, 18e 3-7
CHAPTER 3 NAME #
10-MINUTE QUIZ B SECTION
Enter the following transactions in the two-column journal provided for Charlie’s Cabinetry. You may
omit explanations.
Mar. 2 Purchased auto cleaning supplies from Robert Suppliers for $750 on account.
4 Collected an account receivable of $525 from a customer, Elegant Kitchens.
5 Paid $275 in partial payment of an account payable to Lucy Co for equipment purchased in
February.
7 Issued capital stock in exchange for $5,600 cash.
9 Purchased office equipment from Diamond’s Warehouse for $3,700; paid $1,700 cash and
issued a note payable due in 90 days for the balance.
Date
General Journal
20__
Mar 2
4
5
7
9
Chapter 03—The Accounting Cycle: Capturing Economic Events
3-8 Instructor’s Resource Manual
CHAPTER 3 NAME #
10-MINUTE QUIZ C SECTION
Capital Financial Advisors, Inc. had the following transactions during January, its first month of
operations:
a Issued to Marvin Tycoon 9,000 shares of capital stock in exchange for his investment of $45,000
cash.
b Borrowed $30,000 from a bank and signed a note payable due in three months.
c Purchased office furniture costing $19,750; paid $6,000 cash and charged the balance on account.
d Paid $6,000 of the amount owed for office furniture.
e Issued an additional 2,000 shares of capital stock to an individual who invests $10,000 in the
business.
Instructions
Record the above transactions directly in the T accounts below. Identify each entry in a T account with
the letter shown for the transaction.
Cash
Office Furnishings
Notes Payable
Accounts Payable
Capital Stock
Chapter 03—The Accounting Cycle: Capturing Economic Events
Financial and Managerial Accounting, 18e 3-9
CHAPTER 3 NAME #
10-MINUTE QUIZ D SECTION
The following transactions occurred during June, the first month of operations for Accurate
Manufacturing:
• Issued 60,000 shares of capital stock to the owners of the corporation in exchange for $600,000
cash.
• Purchased a piece of land for $250,000, making an $80,000 cash down payment and signing a
note payable for the balance.
• Made a $100,000 cash payment on the note payable from the purchase of land.
• Purchased equipment on credit from National Supply for $40,000.
1 Refer to the above data. The balance in the Cash account at the end of June:
a $52,000.
b $350,000.
c $420,000.
d $380,000.
2 Refer to the above data. What are total assets of Precision Manufacturing at the end of June?
a $710,000.
b $890,000.
c $630,000.
d $460,000.
3 Refer to the above data. What is the total of Precision’s liabilities at the end of June?
a $70,000.
b $110,000.
c $200,000.
d $240,000.
4 Refer to the above data. What is the total owners’ equity at the end of June?
a $60,000.
b $110,000.
c $240,000.
d $600,000
Chapter 03—The Accounting Cycle: Capturing Economic Events
3-10 Instructor’s Resource Manual
SOLUTIONS TO CHAPTER 3 10-MINUTE QUIZZES
QUIZ A
1 C
QUIZ B
Learning Objective: 2, 3, 4
Date
General Journal
20__
Chapter 03—The Accounting Cycle: Capturing Economic Events
Financial and Managerial Accounting, 18e 3-11
QUIZ C
Learning Objective: 2, 3, 4
QUIZ D
Chapter 03—The Accounting Cycle: Capturing Economic Events
3-12 Instructor’s Resource Manual
Assignment Guide to Chapter 3
Brief
Exercises
Exercises
Problems
Cases
Net
Item Number
1 – 10
1 – 15
1
2
3
4
5
6
7
8
1
2
3
4
Time estimate (in minutes)
< 10
< 15
30
30
35
50
60
50
50
50
15
30
5
10
Difficulty rating
E
E
M
M
M
S
S
S
S
S
M
S
E
E
Learning Objectives:
1
1, 15
1. Identify the steps in the accounting
cycle and discuss the role of
accounting records in an
organization.
2. Describe a ledger account and a
1, 3, 6, 7,
ledger.
1
2
1, 3, 6, 7,
8
1, 3, 6, 7,
10, 11, 12
revenue, and expenses.
5, 6, 7, 8,
13, 14
9, 10
12, 13, 14
1
11, 12
Chapter 03—The Accounting Cycle: Capturing Economic Events
Financial and Managerial Accounting, 18e 3-13
Brief
Exercises
Exercises
Problems
Cases
Net
10. Distinguish between accounting
cycle procedures and the
knowledge of accounting.
1
1, 15