Principles of Financial Accounting: The Accounting Cycle Source Documents

What It Is

Source documents are the original records of business transactions that provide evidence of financial activity. These documents are essential in financial accounting as they serve as the basis for recording, classifying, and reporting financial information. If a company buys $10,000 of inventory, the source document would be the purchase order or invoice, which would be used to record the transaction in the general ledger.

Key Concepts & Formulas

• Source Document: The original record of a business transaction, such as a purchase order, invoice, or receipt.
  • Example: A company receives a purchase order from a supplier for $5,000 worth of office supplies.
• Journal Entry: A record of a transaction in the general ledger, which includes the date, account names, and amounts.
  • Example: A company records a purchase of office supplies for $5,000 in the general ledger.
• Debit: An entry in the left column of a T-account, which increases asset or expense accounts.
  • Example: A company debits Office Supplies $5,000 to record the purchase of office supplies.
• Credit: An entry in the right column of a T-account, which increases liability or equity accounts.
  • Example: A company credits Accounts Payable $5,000 to record the purchase of office supplies on credit.
• Asset Turnover Ratio: A formula that measures the efficiency of a company's use of assets.
  • Formula: Asset Turnover Ratio = Sales / Total Assets
  • Example: A company has sales of $100,000 and total assets of $50,000, so the asset turnover ratio is 2.
• Gross Profit Ratio: A formula that measures the profitability of a company's sales.
  • Formula: Gross Profit Ratio = Gross Profit / Sales
  • Example: A company has gross profit of $20,000 and sales of $100,000, so the gross profit ratio is 0.20.

Journal Entry Examples

Example 1: Purchase of Office Supplies

Dr. Office Supplies $5,000 Cr. Accounts Payable $5,000

Explanation: The company debits Office Supplies to increase the asset account and credits Accounts Payable to increase the liability account.

Example 2: Sale of Goods

Dr. Accounts Receivable $10,000 Cr. Sales $10,000

Explanation: The company debits Accounts Receivable to increase the asset account and credits Sales to increase the revenue account.

Example 3: Payment of Accounts Payable

Dr. Cash $5,000 Cr. Accounts Payable $5,000

Explanation: The company debits Cash to decrease the asset account and credits Accounts Payable to decrease the liability account.

Common Mistakes

Mistake 1: Confusing Debits and Credits for Expense Accounts

• Correction: Remember that debits increase asset or expense accounts, while credits increase liability or equity accounts. Use the mnemonic "ADE" (Assets, Drawings, Expenses) to help you remember.

Mistake 2: Not Recording Source Documents

• Correction: Always record source documents in the general ledger to ensure accurate financial reporting.

Mistake 3: Not Balancing Journal Entries

• Correction: Always balance journal entries to ensure that debits equal credits.

Exam Tips

Tip 1: Remember "ADE" for Debits

• A debit increases assets AND expenses – remember "ADE" (Assets, Drawings, Expenses).

Tip 2: Watch for Reversing Normal Balances

• Be careful when recording journal entries, as reversing normal balances can lead to errors.

Tip 3: Use Source Documents to Support Journal Entries

• Always use source documents to support journal entries and ensure accurate financial reporting.

Quick Practice

Problem 1: Adjusting Entry for Accrued Salaries

What is the adjusting entry for accrued salaries of $5,000?

Answer: Dr. Salaries Expense $5,000 Cr. Accrued Salaries $5,000

Explanation: The company debits Salaries Expense to increase the expense account and credits Accrued Salaries to increase the liability account.

Problem 2: Journal Entry for Purchase of Office Supplies

A company purchases office supplies for $10,000 on credit. What is the journal entry?

Answer: Dr. Office Supplies $10,000 Cr. Accounts Payable $10,000

Explanation: The company debits Office Supplies to increase the asset account and credits Accounts Payable to increase the liability account.

Problem 3: Gross Profit Ratio

A company has gross profit of $20,000 and sales of $100,000. What is the gross profit ratio?

Answer: 0.20

Explanation: The gross profit ratio is calculated by dividing gross profit by sales.

Last-Minute Cram Sheet

1. ⚠️ Source documents are the original records of business transactions.
2. Debits increase asset or expense accounts, while credits increase liability or equity accounts.
3. Journal entries must be balanced to ensure accurate financial reporting.
4. Accrued salaries are recorded as an adjusting entry.
5. The gross profit ratio is calculated by dividing gross profit by sales.
6. ⚠️ Dividends are NOT an expense – they go directly to retained earnings.
7. The asset turnover ratio measures the efficiency of a company's use of assets.
8. The gross profit ratio measures the profitability of a company's sales.
9. ⚠️ Reversing normal balances can lead to errors in financial reporting.
10. Always use source documents to support journal entries.