2

A Review of the Accounting Cycle

Overview
This chapter covers the nuts and bolts of basic accounting, or rather basic bookkeeping.
Accounting tends to cover much wider territory, and it features much more analysis,
when compared with bookkeeping. Accountants do need to know how to do
bookkeeping, however. If for no other reason, then they at least need to learn
bookkeeping to be able to understand much of the remainder of the textbook which
relies on a solid foundation in understanding how the accounting cycle works and how
transactions flow through an accounting system.
Accounting entries can be broken down into three categories: recording entries (LO2),
adjusting entries (LO3), and closing entries (LO3). The vast majority of entries fall into
the first category. The final category of closing entries are only made once a month,
quarter, or year depending on how often the company closes out it books in order to
issue financial statements.
Finally, the chapter discusses the importance, an ever-increasing role, of computers in
the field of accounting.

Learning Objectives
Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that
this section of the chapter is second nature to you before you attempt the homework, a
quiz, or exam. This important piece of the chapter serves as your CliffsNotes or cheat
sheet to the basic concepts and principles that must be mastered.
If after reading this section of the chapter you still dont feel comfortable with all of the
Learning Objectives covered, you will need to spend additional time and effort reviewing
those concepts that you are struggling with.
The following Tips, Hints, and Things to Remember are organized according to the
Learning Objectives (LOs) in the chapter and should be gone over after reading each of
the LOs in the textbook.

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Chapter 2

Tips, Hints, and Things to Remember

LO1 Identify and explain the basic steps in the accounting process
(accounting cycle).
How? Synthesize the steps of the accounting process down into these easy-toremember components. There are three types, or categories, of accounting entries as
mentioned on page 2-1. In between those entries come trial balances, and at or near
the end of the process come the financial statements.

LO2 Analyze transactions and make and post journal entries.

How? Debits and credits, credits and debits: How is one to ever remember which is
which? Do I really have to memorize something as complicated as Exhibit 2-2? The
answer is no. Debits and credits are much simpler than that. You really only need to
remember two things: the basic format of a balance sheet and that debits are on the left.
Everything else flows out of those two easy-to-remember items.
In this textbook balance sheets usually have assets at the top, followed by liabilities and
equity. Instead, picture in your mind (or better yet sketch out) a balance sheet with
assets on the left and liabilities/equity on the right. This way the totals for both columns
will be equal in the same row at the bottom since Assets = Liabilities + Equity.
Next, think of the income statement as part of equity. We learned in this chapter that
nominal or temporary (income statement) accounts get closed out to equity. (Ultimately,
revenue and gains will increase equity and expenses and losses will decrease equity.
So revenue moves in the same direction as equity and expenses move in the opposite
direction.)
With that nested income statement in a balance sheet in mind, the only thing left to
remember is that debits are on the left. The effects of debits and credits flow out of this
model with ease. Since assets are on the left of our balance sheet they increase with
debits (and decrease with credits). Since liabilities and equity are on the right of our
balance sheet they increase with credits (and decrease with debits). Again, think of the
income statement as part of equity with revenue and gains being the same as equity for
debit/credit purposes and expenses and losses being the opposite (since they decrease
equity).
This is also a good way to remember that your debits and credits must always equal. If
they didnt, your balance sheet would no longer balance.
Thats it! Youve now got debits and credits down without having to memorize more than
a dozen items (which youd surely get confused or backwards at times) like youll find in
illustrations like Exhibit 2-2.

Chapter 2

2-3

Feel free to crank out something like the following illustration when given a debit/credit
homework assignment or attempting a debit/credit problem on an examination. Draw it
before you ever start the assignment or problem. Youll find that after drawing and using
it a few times youll no longer need it as it will easily stick to your brain as a mental
image with a little practice.
Balance Sheet

Assets

Liabilities

+DR
cr

+CR
dr
Equity
Income
Statement
Rev. +CR
Exp. +DR

=
How? Whats the difference between journals and ledgers? The difference is that
transactions start out in journals (or at least did historically) and end up in ledgers. To
avoid getting them flip-flopped in your head, remember that the letter j comes before l in
the alphabet just as transactions go through journals before ledgers. Ledgers look more
like your checkbook. Ledgers show account balances and adjustments to specific,
individual accounts. Journals provide more details about a transaction (including all the
accounts affected) and tell you what really happened in total.

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Chapter 2

Why? Are journals and ledgers even used in todays computerized environment? The
answer is yes and no. Fewer transactions are entered into journals with todays
software programs. However, most software programs still keep the journals in the
background, which are available more as a kind of report now than anything else.
Adjusting and infrequent entries are also still frequently recorded through the general
journal. Common entries, such as sales and purchases, are now generally run through
a sales order system or a purchasing system which journalize the transactions into the
correct accounts behind the scenes. Posting is one item that has been rendered nearly
obsolete due to the computer. Posting still happens, of course, but it is typically
automatic and not usually subject to the common user errors (forgetting to post, posting
to the wrong account, or transposing numbers upon posting) that existed in manual
accounting systems. Ledgers are just as important in a computerized environment as
ever.

LO3 Make adjusting entries, produce financial statements, and close

nominal accounts.
How? Adjusting entries is an area that students frequently struggle with. Part of the
problem is that there is more than one way to enter an original transaction or the
corresponding adjusting entry. For instance, lets say I purchase some supplies. Should
I debit an asset called Supplies or an expense called Supplies Expense? The answer
is it doesnt matter. If you dont plan to use the supplies before the next accounting
period ends then an asset is probably better, and if you plan to use them all before the
end of the period then an expense is probably better. But if you plan to use up only
some of the supplies then it doesnt matter at all. What does matter is that you adjust
your account balances before issuing your financial statements.
So here is the key concept to get down when it comes to adjusting entries: Account
balances need to be adjusted so they are correctly stated. That is it. If your physical
count of supplies indicates that you have $500 in supplies, it doesnt matter if your
current supplies balance per your books is $0 or $50,000, you need to move the
balance to $500. Perhaps adjusting entry isnt even the best term to describe the
process. What we are really doing is correcting entries.
Another struggle students encounter is what accounts should be adjusted. Take the
above example. Lets say our Supplies balance per books is $0 but I have $500 in
supplies on hand at the end of the fiscal period. I know, therefore, that I must debit
Supplies by $500 but what do I credit? Students sometimes make the error of hitting the
missing debit or credit to Cash. There are two things to remember about adjusting
entries:
1. Adjusting entries will always affect at least one balance sheet and at least one
income statement account.
2. Cash is never adjusted in an adjusting entry (except in the rare instance in which
cash per count doesnt equal the Cash account on the booksan indication of
other problems to be sure!).

Chapter 2

2-5

So getting back to our missing credit Since Supplies is a balance sheet account, we
should be looking to credit an income statement account (not ever Cash). What income
statement account goes along with our balance sheet account of Supplies? Supplies
Expense, of course. Youll find similar related accounts for other adjusting entries as
well. (Prepaid Rent with Rent Expense, Prepaid Insurance with Insurance Expense,
Interest Payable with Interest Expense, Wages Payable with Wages Expense,
Unearned Revenue with Sales Revenue, etc.)

LO4 Distinguish between accrual and cash-basis accounting.

How? Students sometimes have difficulty understanding the accrual-basis concept.
And then once they do master it, they seem to forget how to do cash-basis which isnt
as difficult. So how does one keep the two separate in their mind? Think of the accrualbasis of accounting as being accounting based on when events transpire without ever
considering cash. Contrast this with the cash-basis of accounting which is basically
checkbook accountingeverything is based on cash.

LO5 Discuss the importance and expanding role of computers to the

accounting process.
See the Why? under LO2 on page 2-4.

The following sections, featuring various multiple choice questions, matching exercises,
and problems, along with solutions and approaches to arriving at the solutions, is
intended to develop your problem-solving and critical-thinking abilities. While learning
through trial and error can be effective for improving your quiz and exam scores, and it
can be a more interesting way to study than merely re-reading a chapter, that is only a
secondary objective in presenting this information in this format.
The main goal of the following sections is to get you thinking, How can I best approach
this problem to arrive at the correct solutioneven if I dont know enough at this point to
easily arrive at the proper results? There is not one simple approach that can be
applied to all questions to arrive at the right answer. Think of the following approaches
as possibilities, as tools that you can place in your problem-solving toolkita toolkit that
should be consistently added to. Some of the tools have yet to even be created or
thought of. Through practice, creative thinking, and an ever-expanding knowledge base,
you will be the creator of the additional tools.

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Chapter 2

Multiple Choice
MC2-1 (LO1) Which of the following is NOT among the first four steps in the accounting
cycle?
a. record transactions in journals
b. record closing entries
c. business documents analyzed
d. post entries to general ledger accounts
MC2-2 (LO2) A routine collection on a customer's account was recorded and posted as
a debit to Cash and a credit to Sales Revenue. The journal entry to correct this error
would be a debit to
a. Cash and a credit to Accounts Receivable.
b. Sales Revenue and a credit to Unearned Revenue.
c. Sales Revenue and a credit to Accounts Receivable.
d. Accounts Receivable and a credit to Sales Revenue.
MC2-3 (LO2) In an accrual accounting system,
a. all accounts have normal credit balances.
b. revenues are recorded only when cash is received.
c. liabilities, owner's capital, and expenses all have normal credit balances.
d. a credit entry is recorded on the right-hand side of an account.
MC2-4 (LO2) Debits and credits are first determined in the accounting process of a
transaction when the
a. entry is recorded in a journal.
b. entry is posted to a subsidiary ledger.
c. trial balance is prepared.
d. financial statements are prepared.
MC2-5 (LO3) If an expense has been incurred but not yet recorded, then the end-ofperiod adjusting entry would involve a(n)
a. liability account and an asset account.
b. liability account and an expense account.
c. equity and a liability account.
d. receivable account and a revenue account.
MC2-6 (LO3) Failure to record wage expense earned by employees at the end of an
accounting period that will be paid on the following Friday results in
a. understated income.
b. understated liabilities.
c. overstated expenses.
d. overstated assets.

Chapter 2

2-7

MC2-7 (LO3) Failure to record the expired amount of Prepaid Insurance Expense would
NOT
a. understate expenses.
b. overstate net income.
c. overstate owners' equity.
d. understate liabilities.
MC2-8 (LO3) The balance in an Unearned Revenue account represents an amount that
is
Collected
Earned
a. Yes
Yes
b. Yes
No
c. No
Yes
d. No
No
MC2-9 (LO4) Which of the following statements regarding accrual versus cash-basis
accounting is TRUE?
a. The FASB believes that cash-basis accounting is appropriate for some
smaller companies, especially those in the service industry.
b. Cash-basis accounting is sometimes used by small, unincorporated
businesses.
c. Application of cash-basis accounting results in an income statement
reporting revenues and expenses.
d. Cash-basis accounting requires a complete set of double-entry records.
MC2-10 (LO5) The use of computers in processing accounting data
a. places responsibility on the information systems designer.
b. eliminates the double-entry system as a basis for analyzing transactions.
c. eliminates the need for financial reporting standards such as those
promulgated by the FASB.
d. always increases document trails used to verify accounting records.

2-8

Chapter 2

Matching
Matching 2-1 (LO2) Listed below are the terms and associated definitions from the
chapter for LO2. Match the correct definition letter with each term number.
___ 1. accounting
process (or
cycle)
___ 2. accounting
system
___ 3. transactions
___ 4. double-entry
accounting
___ 5. debit
___ 6. credit
___ 7. journal entry
___ 8. business (or
source)
document
___ 9. journals
___ 10. special journals
___ 11. general journal
___ 12. account
___ 13. ledger
___ 14. control account
___ 15. posting
___ 16. general ledger
___ 17. subsidiary
ledgers

a. exchanges of goods or services between/among two or

more entities or some other event having an economic
impact on a business enterprise
b. an accounting record used to list a particular type of
frequently recurring transaction
c. a record used to classify and summarize the effects of
transactions
d. an entry on the right side of an account
e. a record used as the basis for analyzing and recording
transactions; examples include invoices, check stubs,
and receipts
f. a collection of accounts maintained by a business
g. procedures used for analyzing, recording, classifying,
and summarizing the information to be presented in
accounting reports
h. an entry on the left side of an account
i. procedures and methods used, including data processing
equipment, to collect and report accounting data
j. an accounting record used to record all business
activities for which a special journal is not maintained
k. the process of summarizing transactions by transferring
amounts from the journals to the ledger accounts
l. the grouping of supporting accounts that in total equal the
balance of a control account in the general ledger
m. the general ledger account that summarizes the detailed
information in a subsidiary ledger
n. a collection of all the accounts used by a business that
could appear on the financial statements
o. a system of recording transactions in a way that
maintains the equality of the accounting equation
p. records in which transactions are first entered, providing
a chronological record of business activity
q. the recording of a transaction in which debits equal
credits; it usually includes a date and an explanation of
the transaction

Chapter 2

2-9

Matching 2-2 (LO3, LO4) Listed below are the terms and associated definitions from
the chapter for LO3 through LO4. Match the correct definition letter with each term
number.
___ 1. trial balance
___ 2. adjusting
entries
___ 3. contra account
___ 4. nominal
(temporary)
account
___ 5. real
(permanent)
account
___ 6. accrual
accounting
___ 7. cash-basis
accounting
___ 8. post-closing
trial balance

a. used to record subtractions from a related account

b. a list of all real accounts and their balances after the
income statement has been prepared
c. closed to a zero balance at the end of an accounting
period
d. revenues are recognized when earned and expenses are
recognized when incurred
e. revenues and expenses are recorded as they are
received and paid
f. a list of all accounts and their balances
g. not closed to a zero balance at the end of each
accounting period
h. required at the end of each accounting period to update
the accounts as necessary and to fully recognize, on an
accrual basis, revenues and expenses for the period

Exercises
Exercise 2-1 (LO2) Indicate whether a debit will increase (I) or decrease (D) each of
the following accounts
___ 1.
___ 2.
___ 3.
___ 4.
___ 5.
___ 6.
___ 7.
___ 8.
___ 9.
___ 10.
___ 11.
___ 12.
___ 13.
___ 14.
___ 15.
___ 16.
___ 17.
___ 18.

Accumulated Depreciation
Buildings
Cash
Dividends
Dividends Payable
Allowance for Bad Debts
Accounts Receivable
Cost of Goods Sold
Depreciation Expense
Sales Revenue
Retained Earnings
Common Stock
Income Tax Expense
Income Tax Payable
Advertising Expense
Prepaid Advertising
Unearned Revenue
Bad Debt Expense

2-10

Chapter 2

Exercise 2-2 (LO3) For each of the following accounts, indicate by letter with an N (for
nominal) or an R (for real) whether the account is a nominal (temporary) account or a
real (permanent) account.
___ 1.
___ 2.
___ 3.
___ 4.
___ 5.
___ 6.
___ 7.
___ 8.
___ 9.
___ 10.
___ 11.
___ 12.
___ 13.
___ 14.
___ 15.
___ 16.
___ 17.
___ 18.

Accumulated Depreciation
Buildings
Cash
Dividends
Dividends Payable
Allowance for Bad Debts
Accounts Receivable
Cost of Goods Sold
Depreciation Expense
Sales Revenue
Retained Earnings
Common Stock
Income Tax Expense
Income Tax Payable
Advertising Expense
Prepaid Advertising
Unearned Revenue
Bad Debt Expense

Problems
Problem 2-1 (LO2) Record the following transactions and events of the Renato
Galasso Company in general journal form. If the item does not require a journal entry,
write no entry.
a. Sold services worth $8,000 for $1,000 cash and $7,000 on account.
b. Purchased land and building for $80,000 cash and a $320,000 mortgage. The land
was recently appraised at $70,000 and the building at $330,000.
c. Received payment on account, $5,000.
d. Estimated that utilities expense for the coming six months will total $10,000.
e. Paid a cash dividend totaling $13,000.

Chapter 2

2-11

Problem 2-2 (LO2) For each of the journal entries below, write a description of the
underlying event.
a. Cash
Capital Stock

xxx

b. Interest Expense
Notes Payable
Cash

xxx
xxx

c. Cash
Unearned Revenue

xxx

d. Supplies
Cash

xxx

e. Cash
Accounts Receivable

xxx

xxx

xxx

xxx

xxx

xxx

Problem 2-3 (LO3) The information listed below was obtained from the accounting
records, by taking physical counts, and through inquiry of employees of Ringrose
Company as of December 31, 2011.
a. Interest on a note receivable of $400 had been earned, but none of it had been
received or recorded by December 31, 2011.
b. On December 28, 2011, Ringrose received $5,000 in cash in advance for services to
be performed in 2012. The $5,000 was credited to Sales Revenue.
c. Building and land were purchased in 2000 for $780,000. The building's fair market
value was $650,000 at the time of purchase. The building is being depreciated over
a 25-year life using the straight-line method, and assuming no salvage value.
d. On November 1, 2011, $100,000 was loaned to a shareholder on a 6-month note
with interest at an annual rate of 12 percent. Interest is due at maturity. No interest
was accrued at the end of November.
e. Accrued salaries and wages are $3,100 at December 31, 2011. They will be paid on
January 4, 2012.
f. The Office Supplies account has a balance of $3,500. An inventory of supplies
revealed a total of only $500 actually on hand.
Prepare journal entries to adjust the books of Ringrose Company at December 31,
2011.

2-12

Chapter 2

Problem 2-4 (LO3) The following incomplete list of account balances pertain to the
Chesnut Company at December 31, 2011 (before adjusting entries).

Accounts Receivable
Allowance for Bad Debts
Inventory
Prepaid Insurance
Equipment
Accumulated Depreciation
Interest Payable
Notes Payable
Unearned Revenue

Debit
$ 55,000

Credit
$

500

99,000
3,000
300,000
120,000
0
50,000
75,000

Additional information:
a. The controller and the credit manager agreed that, based on an aging of year-end
accounts receivable, the Allowance for Bad Debts account should be increased to
$5,000.
b. The credit manager determined that a customer account with a balance of $1,000
was uncollectible (without regard to the information in a above).
c. The note payable is dated August 31, 2006, and bears interest at 12 percent per
annum. The note and interest are payable at maturity on July 31, 2012.
d. The Prepaid Insurance balance arose from the payment of an annual premium on
June 30, 2011 of $3,000.
e. The inventory at December 31, 2011, was $98,000 as determined by physical count.
f. The equipment, purchased five years ago, is being depreciated over a ten-year
estimated useful life.
g. The unearned revenue represents an amount received for a long-term equipment
rental to another company. The cash ($75,000) was received on June 26, 2011, and
represents prepayment of a one-year rental beginning July 1, 2011.
Prepare adjusting entries to Chesnut Company's accounts at December 31, 2011. Each
entry should be made in general journal format. Identify each entry by using the letter of
the paragraph containing the additional information for the entry. Note that entry b is not
really an adjusting entry (and hence wont affect one balance sheet and one income
statement account like adjusting entries typically do).

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2-13

Problem 2-5 (LO3) Presented below is the December 31 trial balance of Coles
Company.
Coles Company
Trial Balance
December 31, 2011

Cash
Accounts Receivable
Allowances for Bad Debts
Inventory
Furniture and Equipment
Accumulated Depreciation
Prepaid Insurance
Notes Payable
Common Stock
Sales
Cost of Goods Sold
Sales Salaries Expense
Advertising Expense
Administrative Salaries Expense
Office Expense

Debit
$ 14,800
33,600

Credit

2,160

62,400
67,200
26,880
4,080
22,400
72,000
480,000
320,000
40,000
5,360
52,000
4,000
$603,440

$603,440

Prepare the closing entries for Coles Company. What was Coles Companys net income
for the period just ended?
Problem 2-6 (LO4) Manami Company earned $50,000 during 2011 and incurred
expenses (except taxes) of $30,000. They only collected $30,000 of their earnings,
however, as their Accounts Receivable balance increased by $20,000 during 2011.
Manami Company incurred all of their expenses on credit, paying off $20,000 of them,
meaning their Accounts Payable account increased by $10,000 during 2011.
Manami Company obtained a loan of $10,000 on the last day of the year. Assuming a
30 percent tax rate and $5,000 in taxes actually paid, what is Manami Companys net
income on an accrual basis for 2011? On a cash basis, did their cash increase or
decrease and by how much for 2011?

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Chapter 2

Solutions, Approaches, and Explanations

MC2-1
Answer: b
Approach and explanation: Notice the not. Underline it, highlight it, circle it, or do
whatever it takes so that you dont just immediately choose the first choice that is one of
the first four steps.
Always examine the exhibits in the chapter. Dont skip them just because they arent
part of the main text body or because some are quite large. They arent put there merely
to take up space and allow you to read a long chapter faster by only having to deal with
the main body of text. Some are of critical importance and some should actually be
committed to memory. Exhibit 2-1 is one that should be read but need not be
memorized. Get a feel for the accounting process and where things fit, but there is little
value in knowing, for instance, that Step 5 is Adjustments.
Notice, from Exhibit 2-1, that the first few steps involve getting a companys day-to-day
transactions into the system. That is only logical. A company cant close the books or
issue financial statements without first processing the normal transactions. The latter
stages of the accounting process are going to be the items that come after the day-today transactions, at month, quarter, or year end (what accountants in the industry refer
to as the close), which is their busiest time of the month. These items include adjusting
the books, closing the books, and the creation of financial statements.
So for a question like this, if it asks for first steps you are looking for day-to-day
transaction activity, and if it asks for last steps (as in this case), you are going to look for
end-of-period activity. Choices a, c, and d are the day-to-day activities so choice b, an
end-of-period activity, is going to be the only logical choice.
MC2-2
Answer: c
Approach and explanation: If you are a visual learner, it may help to sketch out Taccounts for the accounts involved. There are examples of T-accounts in the textbook in
LO3 for this chapter. Basically, one for Cash would look like the following:
Cash

A T-account represents what is happening to an accounts balance in the general

ledger. Numbers on the left are debits that increase asset account balances, and
numbers on the right are credits that decrease asset account balances.

Chapter 2

2-15

It may also be useful to give a problem some real numbers. So, in this case, lets say
$1,000 was collected from the customer. First, lets sketch out how the transaction
should have been recorded. A routine collection on a customers account is going to
increase Cash and decrease Accounts Receivable (since the customer no longer owes
the money). In debit/credit or T-Account format, they will look like the following:

Cash
1,000

Accounts
Receivable
1,000

Instead of making the above entry, the entry was erroneously recorded and posted like
the following:
Cash
1,000

Sales Revenue
1,000

Looking at it visually, we can easily see that Cash is OK. We dont need to do anything
to fix it. Hence, any choice with Cash in it can be crossed out. Unearned Revenue
wasnt included in our recorded transaction; nor would it have been included had we
recorded things correctly the first time. Hence, any choice with Unearned Revenue in it
can also be crossed out. Goodbye choices a and b!
We can also see that both Sales Revenue and Accounts Receivable are now too high
by $1,000. We need to get rid of the credit to Sales Revenue and include a credit to
Accounts Receivable to right things like the following:
Accounts
Receivable
1,000

Sales Revenue
1,000

Now the account balances are where they should have been to begin with had the
erroneous entry not been made. Cash has a debit of $1,000, Accounts Receivable has
a credit of $1,000, and Sales Revenue has nothing from the transaction. Choice c
describes this entry and is, hence, the correct answer.

2-16

Chapter 2

MC2-3
Answer: d
Approach and explanation: First, think of the definition of accrual (which is covered in
LO4not LO2). Under the accrual method, revenues are earned when a good is
delivered or when a service is performednot necessarily when cash is received.
Expenses are recognized when an item is consumed or as incurrednot necessarily
when cash is paid. Therefore, choice b cannot be correct. The other choices have more
to do with an accounting system than accrual measurement.
Remember that debits go on the left and credits on the right. Debits and credits are no
more mysterious than that. One isnt good or bad. Therefore, choice d is a true
statement. Choices a and c are both false because assets (left-hand side of the balance
sheet) and expenses (contra-kind of account to equity which is on the right-hand side of
the balance sheet) both have normal debit balances.
MC2-4
Answer: a
Approach and explanation: Remember from the How? under LO2 on page 2-3 that
transactions start in journals and then move on to ledgers. From the ledgers, a trial
balance can be derived. Financial statements are the last step in the process, the data
used to prepare them coming from the trial balance. There are no debits and credits in
the financial statements, but there are in the other three choices. So the question gets
back to which comes first and that would be the journal. The debits and credits first
determined (to initially record the entry in a journal) merely flows through to the other
items. The numbers dont switch from being a debit to being a credit (or vice versa)
when they are posted to ledgers or when eventually listed as part of an account balance
in a trial balance.
MC2-5
Answer: b
Approach and explanation: What do adjusting entries involve? At least one balance
sheet and at least one income statement account. With that in mind, you can safely
cross out choices a and c. Since the expense has not yet been recorded, you know that
the answer has to include an expense account, so that eliminates choice d. Through a
process of elimination, you now know that the correct choice must be b.
Incurred (or accrued) expenses are frequently the most common type of adjusting entry.
Examples include wages earned by employees but not yet paid, interest incurred on
debt that is not due until the following month or at maturity of the debt, taxes for the
period that will be paid in the following period, and utilities and other kinds of bills that
have been received for costs that have been incurred (or costs that have been incurred
for which the bill has yet to be received) which are still owed at period end and will be
paid in a subsequent period.

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2-17

MC2-6
Answer: b
Approach and explanation: Before looking at the choices, write down what the journal
entry is to record the accrual of wages as follows:
Salaries and Wages Expense
Salaries and Wages Payable

xxx
xxx

Then think of what this (or rather the lack of the above entry) means to the accounting
system. It means that expenses are understated, and hence, income is overstated and
so is equity once income is closed out to Retained Earnings. It also means that liabilities
are understated.
MC2-7
Answer: d
Approach and explanation: There are two things you should do before ever looking at
the choices. The first is to circle, underline, or highlight not in the question. The second
is to write out what the entry would be to record expired prepaid insurance. You should
come up with the following:
Insurance Expense
Prepaid Insurance Expense

xxx
xxx

Then, looking at the above entry, think, or better yet write out, what would happen if this
didnt take place. Answers include the following:
Expenses are understated.
Net income is overstated.
Retained earnings will eventually (after the closing entry) be overstated.
Equity will eventually (after the closing entry) be overstated.
Assets are overstated.
Now you can look at the choices and see that three of them match the list. Liabilities
arent affected, so it being off is the correct choice (since we are looking for the not).
One final point to make, in case you missed it while reading the chapter in the textbook,
is that Prepaid Rent Expense or Prepaid Insurance Expense is a tricky name for an
asset. A caution in the textbook explained that prepaids are always assets and should
not be confused with expenses found on the income statement even if they have the
word expense in the account name. (In practice you will see the accounts called various
names including, for instance, Prepaid Insurance Expense or just Prepaid Insurance
which reduces the confusion.)

2-18

Chapter 2

MC2-8
Answer: c
Approach and explanation: Recall that unearned revenues are amounts that have come
in from customers that have yet to be earned. (To the customer, these are prepaids.
Prepaids and unearned items are therefore two sides of the same coin. What is an
unearned revenue to one company is a prepaid asset to another company.) Do not
confuse the Unearned Revenue account with revenues on the income statement.
Unearned revenues are never on the income statement. They are always liabilities.
They are liabilities because a service must be rendered or a good must be provided for
them (or they could be refunded). In any event, they are not revenues, have not been
earned (yet), and are an obligation of the company who has them.
For these types of questions (which are frequent in accounting courses and on the CPA
exam) in which you have columns of possibilities, go down each column independently
of the other(s) and circle the correct answer(s). So for this one, go down the Earned
column and circle the correct choices c and d (No). Then go down the Collected column
and circle the correct choices a and c (Yes). The only choice for which you have circled
both answers is the correct one, choice c.
MC2-9
Answer: b
Approach and explanation: This one is a little bit tricky since choices a and b look
similar, and therefore, both might be thrown out as false on that basis. However,
choices c and d are both clearly false.
Income statements are prepared on the accrual basis, not the cash basis. Revenues do
not equal cash inflows (usually), and expenses do not equal cash expenditures
(usually).
The cash basis does not require a complete set of double-entry records. The cash basis
can be thought of, as mentioned previously, as checkbook accounting. Double entries
are not required in checkbook accounting. All one needs to know on the cash basis is
what cash came in and what cash went out.
So now we turn back to choices a and b to find out which one is the true one. Choice b
is correct since businesses not required to follow FASB (because they have no creditors
requiring financial statements prepared in accordance with GAAP and because the IRS
allows some small businesses to report their accounting information on a cash basis)
can use the cash basis. Choice a is incorrect because FASB requires GAAP and GAAP
is on the accrual basis (for the balance sheet and income statement at least).

Chapter 2

2-19

MC2-10
Answer: a
Approach and explanation: The key point made in LO5 is that professional judgment is
just as important as ever with the advent of computers processing accounting data.
Other points made included that document trails can be lost if the system isnt
adequately designed and the importance of a good design in the creation of the
information system.
Financial reporting standards are not affected by computers at all. Hence, choice c can
be eliminated. Answers that include the word always are always suspect (pun
intended). Circle the word always or never when you encounter it in a multiple choice
question just like you would the word not. Choices with always or never are seldom
the correct answer and choice d is no exception. If choice b were the correct one, do
you really think the chapter would also talk about the double-entry system?
Matching 2-1
1.
g
2.
i
3.
a
4.
o
5.
h
6.
d
7.
q
8.
e
9.
p
10.
b
11.
j
12.
c
13.
f
14.
m
15.
k
16.
n
17.
l
Complete these terminology matching exercises without looking back to the textbook or
on to the glossary. After all, you probably wont have those as a reference at test time.
Learning through trial and error causes the item to be learned better and to stick in your
memory longer than if you just look to the textbook, glossary, or a dictionary and cook
book the answers. Sure you may get the answer correct on your first attempt, but
missing something is sometimes best for retention. Dont be afraid of failure while
studying and practicing.

2-20

Chapter 2

Matching 2-2
1.
f
2.
h
3.
a
4.
c
5.
g
6.
d
7.
e
8.
b
Exercise 2-1
If debits and credits are still giving you problems, sketch out the diagram on page 2-3
for the first nine of these accounts. Then cover it up for the last nine and see how you
do. If you miss any, try doing this exercise again tomorrow until you have debits and
credits down well.
1.

2.
3.
4.

I
I
I

5.
6.

D
D

7.
8.

I
I

9.

10.
11.
12.
13.
14.
15.
16.
17.
18.

D
D
D
I
D
I
I
D
I

(Remember that Accumulated Depreciation is a contra-asset account, so it

moves in the opposite direction typical assets move.)

(Be careful! Although Dividends move like expenses, they do not show up
on an income statement.)
(Allowance for Bad Debts is similar to Accumulated Depreciation in that it
is a contra-asset account.)
(As counter-intuitive as it may seem at first glance, expenses do move in
the same direction as assets. Remember that debits are not good or bad
things. They are merely the left side of entries.)
(Since this account increases when Accumulated Depreciation does, it
makes sense that it moves in the opposite direction as Accumulated
Depreciation.)

Chapter 2

2-21

Exercise 2-2
Approach and explanation: There is a hard way and an easy way to determine whether
an account is real or nominal in nature. The hard way is to scrutinize the account and try
to figure each out on a case-by-case basis or (heaven forbid!) to memorize what type
each possible account is.
The easy way is this. Just ask yourself the question, Does this account appear on a
balance sheet? If the answer is yes (because it is an asset, contra-asset, liability, or
equity account), then youve got yourself a real account. If the answer is no, then youve
got yourself a nominal account. This exercise is really that easy.
1.
2.
3.
4.
5.

6.
7.
8.

9.
10.
11.

12.
13.
14.
15.
16.

17.

18.

R (This is an example of a contra-asset account that is not closed out.)

R
R
N (Although Dividends do not appear on an income statement, they are closed
out and are, hence, a nominal rather than real account.)
R (Dont let the Dividends part of the account name fool you; accounts with
Payable in the name will always be liabilities showing up on a balance sheet
and, hence, real in nature.)
R (This is another example of a contra-asset account, offsetting Accounts
Receivable in this case, that is not closed out.)
R
N (One of the few nominal accounts that does not contain Revenue or
Expense in its title. Recall that Cost of Goods Sold is always an expense
and Inventory is always an asset.)
N
N
R (This is the only account involved in closing entries that isnt a nominal
account. It is also the only account involved in closing entries that isnt
closed.)
R
N
R (See the note for #5 above.)
N
R (Prepaids will always be an asset even if they also have Expense in the
account name (e.g., Prepaid Advertising Expense). Hence, they wont be
closed out like their expense counterparts (#15).)
R (Unearned items will always be a liability even if they also have Revenue in
the account name. Hence, they wont be closed out like their revenue
counterparts (#10).)
N

2-22
Problem 2-1
a. Cash
Accounts Receivable
Sales
b. Land
Building
Cash
Mortgage Payable
c. Cash
Accounts Receivable

Chapter 2

1,000
7,000
8,000
70,000
330,000
80,000
320,000
5,000
5,000

d. No entry
e. Dividends (or Retained Earnings)
Cash

13,000
13,000

It is crucial that you know how to record the journal entries for both regular transactions
and adjusting entries by the end of Chapter 2. Hopefully, it is a review topic for you. If
not, or if you are struggling with journal entries, spend the extra time now to master the
topic. Subsequent chapters will expect you to know and understand journal entries.
For part d, recall from Chapter 1 that items are not recognized (recorded) in the
accounting system until something has happened. A transaction has yet to take place
when future costs are merely estimated. Those costs should be recorded in the
companys journal, posted to the accounts, and show up in the financial statements
when they are actually incurred in later periods. Variations on this theme that you may
see are the hiring of employees, the signing of contracts, and the ordering of goods. It is
premature to record any of these items in the accounting records for financial statement
purposes. For management and budgeting purposes, all three of the items and the one
given in d should be somehow noted however.
Problem 2-2
a. Investment of cash by a shareholder in a corporation.
b. Cash payment on a note payable. Part of the payment is for principal and part is for
interest.
c. Received cash in advance for products or services not yet delivered.
d. Purchased supplies for cash and have not used them yet.
e. Received customer payment on account.
Dont look back to Exhibit 2-3 to solve the problem. Try and think through each
transaction until you can come up with what happened.

Chapter 2

2-23

Problem 2-3
Read the How? for LO3 on pages 2-4 and 2-5 if you havent already. With that
information in mind, figure out how to adjust these accounts to get them to the correct
balances, remembering that each of these adjusting journal entries is going to affect at
least one balance sheet account and at least one income statement account. None of
the entries should include a debit or credit to cash since these are adjusting entries.
a. Interest Receivable
Interest Revenue

400
400

b. Sales Revenue
Unearned Sales Revenue

5,000
5,000

c. Depreciation ExpenseBuilding
Accumulated DepreciationBuilding

26,000
26,000

d. Interest Receivable
Interest Revenue

2,000

e. Salaries and Wages Expense

Salaries and Wages Payable

3,100

f. Office Supplies Expense

Office Supplies

3,000

2,000

3,100

3,000

Note for part c: The calculation is 650,000/25 = 26,000. The land is not depreciated, so
you do nothing with the 780,000. The land will be shown on the balance sheet at
130,000 (780,000 650,000).
Note for part d: The calculation is (100,000 0.12)/12 months 2 months (November
and December) = 2,000.
Note for part f: One way to visualize this answer is to create a T-account for Office
Supplies. Fill in the known and then back into the unknown as follows:
Office Supplies
3,500
?
500

2-24

Chapter 2

Problem 2-4
a. Bad Debt Expense
Allowance for Bad Debts

4,500
4,500

b. Allowance for Bad Debts

Accounts Receivable

1,000

c. Interest Expense ($50,000 0.12)/ 3

Interest Payable

2,000

d. Insurance Expense ($3,000/2*)

Prepaid Insurance

1,500

e. Cost of Goods Sold

Inventory

1,000

1,000

2,000

1,500

1,000

f. Depreciation Expense
Accumulated Depreciation

30,000

g. Unearned Revenue ($75,000/2**)

Rental Revenue

37,500

30,000

37,500

* = half the policy period

** = half the rental period

Approach: Recall that for adjusting entries you are getting the accounts to their correct
balances. Therefore, for part a you are effectively doing the following to the Allowance
for Bad Debts balance:
Allowance for
Bad Debts
500
4,500
5,000
For part c, you need to first take a look at the existing balance in the Interest Payable
account. If the interest had been accrued at the end of each of the prior months, the
amount in December would only be for $500 and youd expect a balance in the Interest
Payable account of $1,500. Since the balance is $0, however, you know that it hasnt
been accrued yet, and hence, you need to accrue a full four months worth.
On these open-ended problems, it is a good idea to write down what you do know and
then fill in the missing pieces as you remember them. Dont leave one blank just
because you cant remember both accounts that get entries or because you cant figure
out the amount. For part g, for instance, an answer of

Chapter 2

g. Unearned Revenue

2-25

37,500
37,500

or
g.

37,500
37,500

or
g. Unearned Revenue
Rental Revenue
is better than an answer of
g.

In addition, by filling in what you do know, the answer(s) to the remaining empty
piece(s) may become more apparent.
Problem 2-5
You can cook book this solution by looking at the example given in the textbook. There
is some value in cook booking a solutionespecially if it is for homework that is to be
graded. However, for study purposes, you are better off not cook booking the solution.
Instead, try and do it without looking back to the textbook. If you cant remember how to
do it, then look back to the textbook and review the applicable section that has a similar
example. After doing so, close the textbook and crank out the solution to this practice
problem on your own. Youll learn more as you struggle through it than if you rely
completely on a similar example.
Sales
Retained Earnings
To close revenue accounts.

480,000

Retained Earnings
Cost of Goods Sold
Sales Salaries Expense
Advertising Expense
Administrative Salaries Expense
Office Expense
To close expense accounts.

421,360

480,000

320,000
40,000
5,360
52,000
4,000

2-26

Chapter 2

The net income can be figured in one of two ways. You can take the change in Retained
Earnings (since there are no dividends) as net income (the balance of Retained
Earnings went from $0 to $58,640 with the above entries) or you can simply subtract the
expenses from the revenue. The net income for the period is thus $58,640 (480,000
421,360).
Problem 2-6
Approach and solution: Set up two columns, one for accrual and one for cash, and
record the affects for each of the items under each method as follows:

Manami earned $50,000

Incurred expenses of $30,000
Collected $30,000
Paying off $20,000
Loan of $10,000
30% tax rate
$5,000 in taxes actually paid
Totals

Accrual
$ 50,000
(30,000)
0
0
0
(6,000)
0
$ 14,000

Cash
$

0
0
30,000
(20,000)
10,000
0
(5,000)
$ 15,000

Therefore, net income for 2011 was $14,000. Cash increased by $15,000.
Note that the loan does not affect revenue (it isnt an item that is earned), and hence, it
does increase cash but does not increase revenue and net income. The changes in
Accounts Receivable and Accounts Payable do not affect net income either. They are
there in the problem to show you, in part, why the cash and accrual methods differ.
More on this will be presented in Chapter 5. The income tax expense of $6,000 is
computed as (50,000 30,000) 30 percent.
One final note regarding test-taking strategies and this problem: Remember to always
answer all of the questions in a problem. Sometimes students focus on the first question
(what is net income?) and forget to answer the question about cash (or vice versa). You
may want to circle, underline, or highlight all of the questions in a problem and then
write out the number of answers that you should come up with at the bottom of the
blank space. Here is an example of what your answer sheet might look like before ever
attempting to answer the questions (with the underlines and 4 answers being items
written in by the student):
1. What is 1 + 1? What is 2 + 2? What is 3 + 3? What is 4 + 4?

4 answers

Chapter 2

2-27

2. What is the . . .
When you finish answering question 1, you then see that you should have four answers
written in the blank space above your handwritten 4 answers to check yourself.

Glossary
Note that Appendix C in the rear portion of the textbook contains a comprehensive
Glossary for all of the terms used in the textbook. That is the place to turn to if you need
to look up a word but dont know which chapter(s) it appeared in. The glossary below is
identical with one major exception: It contains only those terms used in Chapter 2. This
abbreviated glossary can prove quite useful when reviewing a chapter, when studying
for a quiz for a particular chapter, or when studying for an exam which covers only a few
chapters including this one. Use it in those instances instead of wading through the 19
pages of comprehensive glossary in the textbook trying to pick out just those words that
were used in this chapter.
account

A record used to classify and summarize the effects of transactions.

accounting process The procedures used for analyzing, recording, classifying, and
summarizing the information to be presented in accounting reports; also referred to
as the accounting cycle.
accounting system The procedures and methods used, including data processing
equipment, to collect and report accounting data.
accounts payable Amounts due for the purchase of materials by a manufacturing
company or merchandise by a wholesaler or retailer.
accounts receivable Trade receivables that are not evidenced by a formal agreement
or note; accounts receivable are usually unsecured open accounts and represent
an extension of short-term credit to customers.
accrual accounting A basic assumption that revenues are recognized when earned
and expenses are recognized when incurred without regard to when cash is
received or paid.
adjusting entries Entries required at the end of each accounting period to update the
accounts as necessary and to fully recognize, on an accrual basis, revenues and
expenses for the period.
business (source) document Business record used as the basis for analyzing and
recording transactions; examples include invoices, check stubs, receipts, and similar
business papers.
cash-basis accounting A system of accounting in which revenues and expenses are
recorded as they are received and paid.

2-28

Chapter 2

closing entries Entries that reduce all temporary accounts to a zero balance at the
end of each accounting period, transferring the preclosed balances to a permanent
account.
contra account An account used to record subtractions from a related account. Also
called an offset account.
control account A general ledger account that summarizes the detailed information in
a subsidiary ledger.
credit An entry on the right side of an account.
debit

An entry on the left side of an account.

double-entry accounting A system of recording transactions in a way that maintains

the equality of the accounting equation: Assets = Liabilities + Owners Equity.
general journal An accounting record used to record all business activities for which
a special journal is not maintained.
general ledger A collection of all the accounts used by a business that could appear
on the financial statements.
journals Accounting records in which transactions are first entered, providing a
chronological record of business activity.
journal entry A recording of a transaction in which debits equal credits; it usually
includes a date and an explanation of the transaction.
ledger A collection of accounts maintained by a business.
nominal (temporary) accounts Accounts that are closed to a zero balance at the end
of an accounting period.
post-closing trial balance A list of all real accounts and their balances after the
closing process has been completed.
posting The process of summarizing transactions by transferring amounts from the
journals to the ledger accounts.
real (permanent) accounts Accounts that are not closed to a zero balance at the end
of each accounting period.
special journal An accounting record used to list a particular type of frequently
recurring transaction.
subsidiary ledgers A grouping of supporting accounts that in total equal the balance
of a control account in the general ledger.
transactions Exchanges of goods or services between/among two or more entities or
some other event having an economic impact on a business enterprise.
trial balance

A list of all accounts and their balances.