Questions and Answers

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1 Questions and Answers 1. List and describe the major steps in the accounting cycle. 2. In accounting, debit and credit have specific meanings. What are they? 3. You overheard one of your friends telling another person that all credits must be good because every time she deposits money in the bank, she gets a credit memo. Is her reasoning correct? If not, explain the meaning of credit in accounting. 4. Complete the following chart by entering either increases or decreases on the appropriate line: Accounts Left Side Right Side Assets Liabilities Stockholders equity 5. In recording any transaction, the total of debits must equal that of credits. Why? 6. When the account Sales Revenue is increased, it involves a credit. Why? 7. Complete the following chart by entering either debit or credit on the appropriate line: Accounts Increase Decrease Accounts Receivable Accounts Payable Cash Inventory Wages Payable Paid-in Capital Sales Cost of Goods Sold Rent Expense Dividends

2 8. Complete the following chart by indicating whether each account is an asset, liability, or stockholders equity account and its normal balance (either debit or credit): Account Type of Account Normal Balance Accounts Receivable Buildings Cash Taxes Payable Prepaid Rent Land Paid-in Capital Cost of Goods Sold Wages Expense Sales Fee Revenue Accounts Payable Marketable Securities 9. Briefly explain to your friend, who has no knowledge of accounting, the purpose of a journal entry. 10. What is a trial balance? 11. Which financial statements can be prepared from information contained in a trial balance? 12. What is the purpose of adjusting entries? 13. Why are adjusting entries normally made at the end of the accounting period? 14. Interpret the following adjusting entries. What business events are being accounted for? Insurance Expense 1,200 Prepaid Insurance 1,200 Unearned Consulting Revenue 2,000 Consulting Revenue 2,000

3 15. What is the purpose of closing entries? When are they made? Describe the logic of debiting revenue accounts during the closing process. 16. What accounts are closed? Why these accounts? 17. Because computers now take care of all of the routine accounting functions, there is no need to know anything about debits, credits, journals, posting, T accounts, and trial balances. Comment. Solutions to Questions 1. Step 1. Analyze Transaction Step 2. Record the Effect of Transactions in a Journal Entry Step 3. Summarize the Effects of Transactions Part 1. Post Journal Entries to the Ledger Part 2. Prepare a Trial Balance Step 4. Prepare Reports Part 1. Make Adjusting Entries Part 2. Prepare Financial Statements Part 3. Close the Books 2. In accounting, debits appear on the left side of the T accounts and credits appear on the right side of the T accounts. Debits are used to represent increases in assets, expenses, and dividends, whereas credits are used to represent increases in liabilities, stockholders equity, and revenues. The correct application of the debit and credit rules ensures that the accounting equation will always stay in balance. For this reason, this system of accounting is often referred to as double-entry accounting. 3. A credit is merely an entry on the right side of any ledger account. It decreases an asset account but increases liability and equity accounts. A credit entry does not imply a favorable or unfavorable condition. Your friend gets a credit memo because when she deposits money in her account, the bank s liability to her is increased and thus is credited.

4 4. Accounts Left Side Right Side Assets Increases Decreases Liabilities Decreases Increases Stockholders equity Decreases Increases 5. Each time accounts are debited, other accounts have to be credited for the same amount. This is a major characteristic of a double-entry accounting system. The total debits must always equal the total credits. Because of the way the debit and credit conventions have been established, maintaining the equality of debits and credits automatically ensures that the accounting equation is always in balance. 6. Increases in revenue accounts are represented by a credit because revenue accounts are equity accounts, temporary sub-categories of retained earnings. The correct application of debits and credits to the revenue accounts ensures that the accounting equation will stay in balance. 7. Account Increase Decrease Accounts receivable Debit Credit Accounts payable Credit Debit Cash Debit Credit Inventory Debit Credit Wages payable Credit Debit Paid-in capital Credit Debit Sales Credit Debit Cost of goods sold Debit Credit Rent expense Debit Credit Dividends Debit Credit 8. Account Type of Account Normal Balance Accounts receivable Asset Debit Buildings Asset Debit Cash Asset Debit Taxes payable Liability Credit Prepaid rent Asset Debit

5 Land Asset Debit Paid-in capital Stockholders equity Credit Cost of goods sold Expense Debit Wages expense Expense Debit Sales Revenue Credit Fee revenue Revenue Credit Accounts payable Liability Credit Marketable securities Asset Debit 9. Journal entries are used to record the effects of transactions in debit and credit language. The use of a journal entry allows us to summarize the accounts affected by the transactions and their respective amounts. 10. A trial balance is a listing of all of the ledger accounts and their balances. The trial balance is used to determine if the posting process was performed correctly. In a correct trial balance, the total of the debit balances is equal to the total of the credit balances. 11. A trial balance can be used to prepare the income statement and balance sheet. Preparation of the statement of cash flows involves analyzing and sorting the transactions in the cash account. 12. Adjusting entries are needed for two reasons: (a) to recognize the proper amounts of revenues earned and expenses incurred during a period of time, and (b) to report the appropriate balances in the asset, liability, and owners equity accounts at a particular date. 13. The accounts that require adjusting entries do not reflect current circumstances at the end of the period. These accounts were not updated throughout the period because it was impractical or inconvenient to make entries on a daily or weekly basis. In order to report all asset, liability, and owners equity amounts properly, and to recognize all revenues and expenses for the period on an accrual basis, accountants are required to make any necessary adjustments prior to preparing the financial statements.

6 14. The prepaid insurance account is adjusted to reflect that portion of the asset that has been used up during the year. An amount was received in advance during the year for consulting revenue. The adjustment is to record the amount of consulting revenue that was actually earned for the year. 15. The revenue, expense, and dividend accounts are used to temporarily keep separate track of the many business events that impact Retained Earnings during the year; at the end of the year, the balances in these accounts are formally transferred to Retained Earnings through closing entries. Closing entries are made at the end of the year or at the end of the accounting period. The purpose of a closing entry to a revenue account is to zero out the account and transfer the amount to Retained Earnings. Revenue accounts have a credit balance, so a debit to the account will close it out to zero. 16. Revenue, expense, and dividend accounts are closed. These accounts are used to temporarily keep track of the business events that impact Retained Earnings. At the end of the year, the total impact of these accounts must be transferred to Retained Earnings. By closing out these accounts, the amounts are transferred to Retained Earnings and the updated balance is reflected in the balance sheet. 17. Although computers automate the accounting process, an accountant still needs to understand debits, credits, journals, posting, T-accounts, and trial balances to be able to understand what the computer is doing. By understanding the overall process, an accountant will be able to analyze and interpret the data. In addition, business people are well advised to understand the accounting process so that they can see how information flows in an organization and so that they can understand the accounting jargon that is often used.

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