Managerial/Cost Accounting, UT Austin | Units 4–5
Difficulty: Introductory to Intermediate Prerequisites: Units 1–3 study notes. You should be comfortable with cost classifications and the CVP equation before tackling the accounting equation and journal entries.
Units 4 and 5 shift from managerial decision-making to the mechanics of financial accounting. Unit 4 introduces the accounting equation (Assets = Liabilities + Stockholders' Equity), the four financial statements, how transactions affect the equation, and the regulatory framework (GAAP, FASB, SEC, SOX). Unit 5 teaches the double-entry system: debits, credits, T-accounts, the general journal, the general ledger, posting, and the trial balance. Together, these units give you the grammar of accounting. Nothing in Units 6 or 7 will make sense without them.
Unit 4 establishes what the financial statements are and how every transaction keeps the accounting equation in balance. Unit 5 shows you the mechanical system (debits and credits) that records those transactions and feeds the statements.
Accounting (financial definition)
The process of identifying, recording, and communicating the economic events of an organisation to interested users.
Accrual accounting
Recording transactions when events occur, not when cash changes hands. Revenues are recognised when the performance obligation is satisfied; expenses are recognised when incurred.
Think of it as: record it when the work happens, not when the cheque clears.
Cash accounting
Recording transactions only when cash is received or paid. Not accepted under GAAP because it does not match expenses with revenues.
Assets
Resources a business owns. In simple terms: what it has.
Liabilities
Obligations or debts a business owes to outsiders.
Stockholders' equity
The owners' residual claim on assets after all liabilities are settled. Equals Common Stock + Retained Earnings.
Retained earnings
Cumulative net income kept in the business, less dividends paid out. Retained Earnings = Revenues - Expenses - Dividends.
Income statement
The financial statement that reports revenues, expenses, and net income (or net loss) for a specific period. Also called the Statement of Operations or Profit and Loss Statement.
Retained earnings statement
Summarises why retained earnings changed during the period: beginning balance + net income - dividends = ending balance.
Balance sheet
Reports assets, liabilities, and stockholders' equity at a specific point in time. A snapshot of financial position.
Statement of cash flows
Summarises cash inflows and outflows from operating, investing, and financing activities for a specific period.
GAAP
Generally Accepted Accounting Principles. The rules that govern how economic events are reported in financial statements.
FASB
Financial Accounting Standards Board. The private-sector body that sets GAAP.
SEC
Securities and Exchange Commission. The government agency that oversees financial markets and accounting standard-setting bodies.
IASB / IFRS
International Accounting Standards Board / International Financial Reporting Standards. The international counterpart to FASB/GAAP.
Sarbanes-Oxley Act (SOX)
Legislation passed to reduce corporate fraud. Requires management to certify the accuracy of financial information and imposes severe penalties for fraudulent activity.
Historical cost principle
Companies record assets at their original purchase cost (past worth).
Fair value principle
Companies record assets at their current market value (current worth).
Debit (DR)
An entry on the left side of a T-account. Increases assets and expenses. Decreases liabilities, stockholders' equity, and revenues.
Credit (CR)
An entry on the right side of a T-account. Increases liabilities, stockholders' equity, and revenues. Decreases assets and expenses.
T-account
A simplified representation of a ledger account with three parts: title, left (debit) side, and right (credit) side.
General journal
The book of original entry. Records the effect of each transaction on the accounts in chronological order.
General ledger
Holds all accounts needed to prepare financial statements. Each account collects every debit and credit posted to it.
Posting
The process of transferring journal entries to the appropriate accounts in the general ledger.
Trial balance
A list of all accounts and their balances after posting. Total debits must equal total credits. If they do not, an error has been made.
Identify: recognise the economic events relevant to the business.
Record: keep a chronological diary of those events in dollars and cents, then classify and summarise them.
Communicate: deliver the information to users through accounting reports, principally financial statements.
Internal users: managers who plan, organise, and run the business (marketing managers, production supervisors, finance directors).
External users: individuals and organisations outside the company who need financial information (investors, creditors, regulators).
GAAP: the rules governing how economic events are reported.
FASB: the body that sets those rules.
SEC: the government agency overseeing financial markets and the standard-setters.
IASB / IFRS: the international equivalents.
Sarbanes-Oxley (SOX): requires management to certify the accuracy of financial information, increases penalties for fraud, and strengthens the independence of auditors.
Historical cost principle: record assets at their original purchase cost.
Fair value principle: record assets at their current market value.
Assets = Liabilities + Stockholders' Equity
This equation must always balance. Every transaction affects at least two items in the equation, preserving equality.
Stockholders' Equity = Common Stock + Retained Earnings
Retained Earnings = Revenues - Expenses - Dividends
Investment and purchase transactions
Investment by stockholders: increases assets (cash) and increases stockholders' equity (common stock). Not revenue.
Purchase of equipment for cash: increases one asset (equipment), decreases another (cash). Total assets unchanged.
Purchase of supplies on credit: increases assets (supplies) and increases liabilities (accounts payable).
Service transactions
Services performed for cash: increases assets (cash) and increases stockholders' equity (retained earnings via revenue).
Purchase of advertising on credit: increases liabilities and decreases stockholders' equity (retained earnings via expense).
Services performed for cash and on credit: increases assets (cash + accounts receivable) and increases stockholders' equity.
Payment, receipt, and dividend transactions
Payment of expenses: decreases assets and decreases stockholders' equity.
Payment of accounts payable: decreases assets (cash) and decreases liabilities. No effect on equity because the expense was already recorded.
Receipt of cash on account: increases cash, decreases accounts receivable. Total assets unchanged. No equity effect.
Dividends: decreases assets and decreases stockholders' equity. Dividends are not expenses and are excluded from net income.
Income statement: revenues and expenses for a period. Tells you whether the company is making money. Does not include investments or dividends.
Retained earnings statement: beginning retained earnings + net income - dividends = ending retained earnings.
Balance sheet: assets, liabilities, and equity at a point in time. A snapshot of financial strength.
Statement of cash flows: cash inflows and outflows from operating, investing, and financing activities for a period.
The statements are prepared in this order because each one feeds the next. The income statement provides net income for the retained earnings statement, which provides the ending retained earnings figure for the balance sheet.
The entire double-entry system rests on one framework:
Account type | Increased by | Decreased by | Normal balance |
|---|---|---|---|
Assets | Debit | Credit | Debit |
Liabilities | Credit | Debit | Credit |
Common Stock | Credit | Debit | Credit |
Retained Earnings | Credit | Debit | Credit |
Dividends | Debit | Credit | Debit |
Revenues | Credit | Debit | Credit |
Expenses | Debit | Credit | Debit |
A quick way to remember: assets and expenses live on the debit side (they increase with debits). Everything else lives on the credit side.
A T-account is a visual shorthand for any ledger account. The left side is the debit side; the right side is the credit side. If total debits exceed total credits, the account has a debit balance, and vice versa.
Three steps:
Analyse the transaction for its effects on the accounts.
Enter the transaction in the general journal (book of original entry). Each journal entry includes the date, the accounts and amounts debited and credited, and a brief explanation.
Post the journal entry to the general ledger: transfer each debit and credit to the appropriate account.
Debits are written at the left margin; credits are indented to the right.
Enter the date, journal page, and debit amount in the appropriate ledger account.
Write the account number in the journal's reference column for that debit.
Enter the date, journal page, and credit amount in the appropriate ledger account.
Write the account number in the journal's reference column for that credit.
After posting, prepare a trial balance: list every account and its balance. Add all debit balances and all credit balances separately. If the totals are not equal, an error has been made somewhere in the recording or posting process.
The trial balance proves mathematical equality, but it does not guarantee that every transaction was recorded correctly. For example, posting to the wrong account would not cause an imbalance.
Formula | Expression |
|---|---|
Basic accounting equation | Assets = Liabilities + Stockholders' Equity |
Stockholders' Equity | Common Stock + Retained Earnings |
Retained Earnings | Revenues - Expenses - Dividends |
Income (Net) | Revenue - Expenses |
Wealth (Owner's) | Assets - Liabilities |
Students often think that dividends are an expense. They are not. Dividends are a distribution of earnings to owners, and they are excluded from the income statement.
Students frequently confuse the receipt of cash on account with new revenue. Collecting an accounts receivable does not generate revenue; the revenue was already recorded when the service was performed. The collection just swaps one asset (receivable) for another (cash).
A common mistake is thinking that the trial balance proves all transactions were recorded correctly. It only proves that debits equal credits. Errors such as posting to the wrong account, omitting a transaction entirely, or recording the wrong amount on both sides will not be caught.
Students mix up which accounts are increased by debits and which by credits. A simple anchor: assets and expenses are debit-normal. Everything else (liabilities, equity, revenue) is credit-normal.
⚠️ Be able to classify any transaction by its effect on the accounting equation. Know which side goes up, which goes down, and whether the equation stays in balance.
⚠️ The debit/credit table is heavily tested. Memorise which account types carry normal debit balances (assets, expenses, dividends) and which carry normal credit balances (liabilities, common stock, retained earnings, revenues).
⚠️ You may be asked to trace a transaction from journal entry to ledger posting to trial balance. Practise the full sequence.
⚠️ Know the four financial statements and the order in which they are prepared: income statement first, then retained earnings statement, then balance sheet, then statement of cash flows.
⚠️ Expect a question testing whether you understand that paying off a previously recorded liability does not create a new expense.
True or False: Dividends reduce net income on the income statement.
Answer: False. Dividends are not an expense and do not appear on the income statement.
Fill in the blank: A debit increases ______ and ______.
Answer: Assets and expenses.
True or False: If a trial balance is in balance, all transactions have been recorded correctly.
Answer: False. A balanced trial balance only proves that total debits equal total credits.
Fill in the blank: The balance sheet reports financial position at a specific ______, not over a period.
Answer: Point in time (date).
True or False: Collecting cash from a customer who owed money on account increases total assets.
Answer: False. Cash goes up, accounts receivable goes down by the same amount. Total assets are unchanged.
Q: A company purchases $3,000 of supplies on credit. What is the effect on the accounting equation?
A: Assets increase by $3,000 (supplies), and liabilities increase by $3,000 (accounts payable). Stockholders' equity is unaffected.
Q: A company performs services for a client and receives $5,000 in cash. Which accounts are debited and credited?
A: Debit Cash $5,000 (asset increases). Credit Service Revenue $5,000 (revenue increases). Both sides of the accounting equation go up: assets and stockholders' equity.
Q: A company pays a $2,000 dividend. Is this an expense? How does it affect the equation?
A: Dividends are not expenses. They reduce assets (cash decreases by $2,000) and reduce stockholders' equity (retained earnings decreases by $2,000).
Q: What is the normal balance of Accounts Payable, and what kind of entry increases it?
A: Accounts Payable is a liability. Its normal balance is a credit balance, and a credit entry increases it.
Q: A company collects $1,500 from a customer who was billed last month. What journal entry is recorded?
A: Debit Cash $1,500. Credit Accounts Receivable $1,500. No revenue is recorded because the revenue was already recognised when the service was performed.
The accounting equation and debit/credit rules from these units are the mechanical foundation for Units 6 and 7. Adjusting entries (Unit 6) and the worksheet and closing process (Unit 7) are simply more journal entries that follow the same debit/credit logic. The financial statements introduced here are the outputs you will learn to adjust and finalise in the next two units.
Financial accounting, accounting equation, assets equals liabilities plus equity, double-entry bookkeeping, debit, credit, T-account, normal balance, general journal, book of original entry, general ledger, posting, trial balance, income statement, retained earnings statement, balance sheet, statement of cash flows, GAAP, FASB, SEC, IASB, IFRS, Sarbanes-Oxley, SOX, historical cost principle, fair value principle, accrual accounting, cash accounting, revenue recognition, internal users, external users, common stock, retained earnings, dividends, accounts payable, accounts receivable