Analyzing and Recording Transactions In this chapter we are going to discuss in-depth the proper procedures to follow in using the double-entry accounting process. You will find this in-depth look a little confusing as you go through the chapter. By the time we get to the last screen, we think you will see just how the system works. The material discussed in this chapter will be used continuously in the remaining chapters devoted to financial accounting. It is a great idea to go slowly though this chapter material. Let’s start the process with a little review. Pr. SAMLAL Zoubida

Procedural Learning Objectives Record transactions in a journal and post entries to a ledger (T account). Prepare and explain the use of a trial balance. Prepare financial statements from business transactions. 2-2

Analyzing and Recording Process Exchanges of economic consideration between two parties. In accounting we generally record transactions involving exchanges of economic consideration between two parties. We have many transactions with external parties like creditors, customers, financial institutions and owners. In addition, we must also look at internal transactions. These type of transactions may involve exchanges between divisions within a company or payments to employees. External Transactions occur between the organization and an outside party. Internal Transactions occur within the organization. 2-3

Analyzing and Recording Process Accounting process: -Identifies business transactions and events, -Analyzes and records their effects, and -Summarizes and presents information in reports and financial statements. Steps in accounts process that focus on analyzing and recording transactions and events are: Record relevant transactions and events in a journal, (2) Post journal information to ledger accounts, and (3) Prepare a trial balance. Accounting records are informally referred as the accounting books, or simply the books.

Analyzing and Recording Process Record relevant transactions and events in a journal Analyze each transaction and event from source documents Post journal information to ledger (T) accounts We begin the accounting process by analyzing source documents. For example, you usually receive a receipt when you pay cash for something. Think about the last time you went to a fast food restaurant. When you received your order you were given a receipt, a source document. If you wanted a company to reimburse you for the meal because you were traveling on company business, you must present evidence of your expenditure. This evidence takes the form of a source document, the receipt. Once we identify a business transaction, we record it in a journal. A journal is arranged in chronological order. Transactions are recorded by date of occurrence. At the end of the accounting period, usually a month, transactions in the journal are posted to a ledger account. Posting is the systematic process of transferring information from the journal to the ledger. The ledger groups transactions by the accounts impacted. For example, we will have a ledger account for cash. All transactions that result in increases or decreases in the cash account will be posted to the cash ledger account. Once all transactions have been posted, we prepare a trial balance. The purpose of the trial balance is to make sure that all information has been transferred properly. The trial balance is a listing of all account balances. Prepare and analyze the trial balance 2-5

Employee Earnings Records Source Documents C 2 Bills from Suppliers Checks Purchase Orders Employee Earnings Records Bank Statements Almost all businesses use sales orders, purchase orders, statements from suppliers, canceled checks, bank statements, shipping notices, packing slips, and the like to support the existence of a transaction. In today’s highly computerized environment many source documents are stored digitally. Knowing how to access these digital source documents is an important part of accounting. Sales Tickets 2-6

The Account and its Analysis An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item. The general ledger is a record containing all accounts used by the company. Here are more complete definitions of account balances and ledger accounts. 2-7

The Account and its Analysis Assets Accounts Asset Accounts = + Liability Accounts Equity Accounts Recall the basic accounting equation from chapter one. It should look familiar. 2-8

Asset Accounts Asset Accounts Cash Accounts Receivable Land Notes Receivable Buildings Here is a listing of common assets accounts we are likely to find in all businesses. Prepaid accounts may be new to you. Think about your auto insurance. Many of us pay our auto insurance semi-annually or annually. The payment is made in advance and is referred to as a prepaid amount. Prepaid Accounts Equipment Supplies 2-9

Liability Accounts Liability Accounts Accounts Payable Notes Payable Dividends Payable Accrued Liabilities This is a listing of common liability accounts we are likely to see in the general ledger. An unearned revenue is one in which the cash has been received but the product or service has not be delivered. If you subscribe to a magazine, you generally pay a one-year subscription in advance. For the publishing company, cash is received but nothing has been done to earn the revenue. As the magazine is delivered to you, the publishing company recognizes a portion of the money received as revenue. At the end of the year, all the revenue will be earned and the liability no longer exists. Unearned Revenue 2-10

Equity Accounts Equity Accounts Retained Earnings Common Stock Dividends Declared Equity Accounts Here is review of the equity accounts we discussed in the last chapter. Revenues Expenses 2-11

The Account and its Analysis = + Assets Liabilities Equity Common Stock Dividends Revenues Expenses + – Do you remember the expanded accounting equation we used to record transactions in chapter one? Remember that revenues increase the equity side of the equation and expenses decrease equity. 2-12

Ledger and Chart of Accounts The ledger is a collection of all accounts for an information system. A company’s size and diversity of operations affect the number of accounts needed. The chart of accounts is a list of all accounts and includes an identifying number for each account. A chart of accounts is a listing of all accounts in the ledger. Notice that all assets accounts begin with an account number of one, all liabilities with two, equities with three, revenues with four, and expenses with six. 2-13

Debits and Credits C 5 A T-account represents a ledger account and is a tool used to understand the effects of one or more transactions. Accountants often use a T-account to represent a general ledger account. It is a quick way to analyze transaction before we enter the information in the journal. The left side of a T-account is always called the debit side, and the right side is always called the credit side. This terminology comes from the time when the first double-entry system was first developed. We still use the terms as a convention. The words do not have any significant meaning other than that they stand for the left and right side of a ledger. 2-14

Double-Entry Accounting NORMAL Balance ASSETS = LIABILITIES + EQUITY DR = CR CR Assets are on the left side of the equation; therefore, the left, or debit side is the normal balance side for assets. Liabilities and equities are on the right side; therefore, the right, or credit side is the normal balance side for liabilities and equity.

Double-Entry Accounting ASSETS = LIABILITIES + EQUITY || ASSETS = LIABILITIES + Common Stock – DIV + REV - EXP Total amount that is debited to accounts must equal the total amount credited to accounts for each transaction. Sum of debit account balances in the ledger must equal the sum of credit account balances.

Double-Entry Accounting NORMAL Balance Liabilities Equity Assets = + Debit Credit ASSETS + - LIABILITIES - + EQUITIES After we decide on the terms to use for the left and right side of a ledger account, we must establish the mathematics of the double-entry system. Liabilities and equity have the opposite sign of assets. If we were to move the liabilities to the left side of the equation, it would read assets minus liabilities equal equity. As a convention of double-entry accounting we have decided that a debit, or left side, to an asset account will represent an increase in the asset account balance. Once this decision is made all the remaining math is determined. Because liabilities and equity have the opposite sign of assets, a debit to a liability or equity account must mean a decrease and a credit means an increase. Instead of using the terms increase and decrease we use the terms debit and credit. It is important to remember whether we are talking about an asset, liability or equity account for the meaning of a debit or a credit. It will take you a short while to become accustomed to using the terms debit and credit, but with practice you will master the concept easily. Whether a debit or a credit is an increase or decrease depends on the NORMAL Balance of the account. 2-17

Double-Entry Accounting NORMAL Balance Equity Revenues Expenses Common Stock Dividends _ + Debit Credit Stock - + Dividends + - Expenses Revenues Here is the expanded accounting equation showing the equity section. Because revenues increase equity, a revenue account must be recorded just like the common stock account. A credit is an increase in revenues and a debit is an increase in expenses. The common stock and revenue accounts are both increased with a credit and decreased with a debit. Dividends and expenses have an opposite sign, so these accounts are increased with a debit and decreased with a credit. 2-18

Double-Entry Accounting NORMAL Balance An account balance is the difference between the increases and decreases in an account. Notice the T-Account We have determined the balance in accounts in the last chapter, but in this chapter we will look at a more comprehensive way to determine an account balance. The cash account is an asset, so increases, or receipts, are shown on the debit, or left side, and decreases, or payments, are shown on the credit side, or right side. To determine if an account has a debit or credit balance, we total the right and left sides and place the balance on the larger side. In this example, our increases in cash amount to thirty-six thousand one hundred dollars and the decreases total thirty-one thousand three hundred dollars so the cash account has a debit, or positive balance of four thousand eight hundred dollars. 2-19

Journalizing & Posting Transactions Step 1: Analyze transactions and source documents. Liabilities Equity Assets = + Step 2: Apply double-entry accounting Step 3: Record journal entry In the accounting process you first analyze a transaction by looking at proper source documentation. Next, we apply the rules of double-entry accounting and record a general journal entry. The general journal is a chronological listing of the transactions. At the end of the accounting period we post the information from the general journal to the proper general ledger account. The general ledger groups all transaction that impact a particular account. That is, all the transactions that increase or decrease the cash account are posted to the cash general ledger account. Step 4: Post entry to ledger 2-20

Journalizing Transactions P1 Transaction Date Titles of Affected Accounts Here is an example of the proper recording of a general journal transaction. We have seen a similar transaction before. In this case, the owner of the business contributes thirty thousand dollars cash to start the business and receives shares of common stock. Let’s see how we get the various pieces. Part I The transaction occurred on December 1, 2009. The date in important when recording general journal transactions and is recorded on the left side of the journal. Part II Next we identify the accounts affected by the transactions. The cash account is an asset that has increased. We show increases in accounts with a debit to that account. The common stock account also increased and we show increases in equity accounts with a credit. Debits are always listed first in the journal followed by credits that are slightly indented below the debits. Part III The dollar amount is place in the appropriate debit or credit column. In this case, the cash account was debited for thirty thousand dollars, so we place that amount in the debit column. Part IV Finally, we prepare a brief description of the transaction so that other people who view our work will understand the nature of the transaction. This explanation is indented about as far as the credited account titles to avoid confusing it with accounts and it is italicized. Transaction explanation Dollar amount of debits and credits 2-21

Balance Column Account P1 T-accounts are useful illustrations, but balance column accounts are used in practice. Here is the balance column account for cash. It looks similar to your checkbook. We have a debit, or increase column, a credit, or decrease column, and a running balance. You can see the cash receipts and payments. The current balance in the cash account at December 10, 2009, is five thousand seven hundred dollars. In the upper right corner of the ledger account, we assign an account number to the cash account. In computer processing of information, numbers are more efficient to use than alpha characters. When we speak of account number one-zero-one, we are referring to the cash account. 2-22

Posting Journal Entries 1 Identify the debit account in ledger. Let’s look at the posting process. We will transfer or “post” the information from the general journal to the proper ledger account. This process is called posting. First, we find the proper account in the general ledger. In our example we used the cash account. 2-23

Posting Journal Entries 2 Enter the date. We transfer the date, December first, to the date column in the general ledger. 2-24

Posting Journal Entries 3 Enter the amount and description. We place a description into the description column and place the debit amount of thirty thousand dollars in the debit column of the cash general ledger account. 2-25

Posting Journal Entries Enter the journal reference. 4 Next, we indicate were you can find the journal entry. In our case, it is on the first page of the general journal. We use the letter “G” to indicate general journal. 2-26

Posting Journal Entries Compute the balance. 5 Now, we update the running balance in the cash account. 2-27

Posting Journal Entries 6 Enter the ledger reference. Back in the general journal, we enter a posting reference of the account number in the proper column. This tells the accountant that the amount has been posted to account number one-zero-one. Now we can go back and forth between the general journal and the general ledger. This is known as a cross-reference. We would follow the same procedures for the common stock account. Let’s begin using the double-entry accounting system. 2-28

Analyzing Transactions Analysis: Double entry: Let’s see if we can analyze transactions and get them into the proper form for double-entry accounting. This will be helpful when you turn to your homework. In the first transaction, on December first, a shareholders invests thirty thousand dollars to start a company called FastForward. From our previous work we know that the cash account and the common stock account will increase. We record this information in the general journal with a debit, increase, to cash, and a credit, increase, to common stock. Notice that the account number for the cash account is one-zero-one and common stock is three-zero-one. We are going to post the information in the journal to the general ledger. We will use t-accounts to accomplish this. We place the thirty thousand dollars on the left, or debit, side of the cash account and on the right, or credit, side of the common stock account. Our books are in balance because total assets are equal to total liabilities plus equity. Let’s move to another transaction. 101 301 Posting: 2-29

Analyzing Transactions Analysis: Double entry: In our second transaction, FastForward purchases office supplies paying twenty-five hundred dollars cash. We have exchanged one asset, cash, for another asset, supplies. The cash account will decrease and the supplies account will increase. Can you make the general journal entry to record this transaction? We increase the supplies account with a debit and decrease the asset account, cash, with a credit. Let’s post the amounts. The general ledger account for supplies increased by twenty-five hundred dollars so the amount is placed on the debit side of the account. The cash account, an asset, decreased by twenty-five hundred dollars, so the amount is placed on the credit side of the general ledger account. Let’s move on to another transaction. 126 101 Posting: 2-30

Analyzing Transactions Analysis: Double entry: In our third transaction, FastForward purchases equipment paying twenty-six thousand dollars cash. Once again, we have exchanged one asset, cash, for another asset, equipment. The cash account will decrease and the equipment account will increase. This general journal entry will look similar to the one we just completed. We increase the equipment account with a debit and decrease the asset account, cash, with a credit. Let’s post the amounts. The general ledger account for equipment increased by twenty-six thousand dollars so it is placed on the debit side of the account. The cash account, an asset, decreased by twenty-six thousand dollars, so the amount is placed on the credit side of the general ledger account. Let’s look at another transaction. 167 101 Posting: 2-31

Analyzing Transactions Analysis: Double entry: In this transaction, FastForward purchases seventy-one hundred dollars of office supplies on account. The supplies account, an asset, will increase and the liability account, accounts payable will increase. Let’s make the general journal entry to record this transaction. We increase the supplies account with a debit and increase the liability account, accounts payable, with a credit. It time to post the transaction. The general ledger account for supplies increased by seventy-one hundred dollars so the amount is placed on the debit side of the account. The accounts payable account, a liability, increased by the same amount, so we place it on the credit side of the general ledger account. Let’s analyze another transaction. 126 201 Posting: 2-32

Analyzing Transactions Analysis: Double entry: FastForward provided consulting services and collected forty-two hundred dollars cash. The asset account, cash, increased by forty-two hundred dollars and the equity account, consulting revenue, increased by the same amount. See if you can make the general journal entry to record this transaction before moving to the next slide. We increase the cash account with a debit and increase the revenue account, consulting revenue, with a credit. Let’s post the amounts. The general ledger account for cash increased by forty-two hundred dollar so the amount is placed on the debit side of the account. The consulting revenue account increased by the same amount, so it is placed on the credit side of the general ledger account. We could continue on with more transaction, but your homework will help reinforce what we have done here. Let’s take a look at the trial balance of FastForward at the end of December. 403 101 Posting:

Analyzing Transactions Analysis: Double entry: FastForward provided consulting services and collected forty-two hundred dollars cash. The asset account, cash, increased by forty-two hundred dollars and the equity account, consulting revenue, increased by the same amount. See if you can make the general journal entry to record this transaction before moving to the next slide. We increase the cash account with a debit and increase the revenue account, consulting revenue, with a credit. Let’s post the amounts. The general ledger account for cash increased by forty-two hundred dollar so the amount is placed on the debit side of the account. The consulting revenue account increased by the same amount, so it is placed on the credit side of the general ledger account. We could continue on with more transaction, but your homework will help reinforce what we have done here. Let’s take a look at the trial balance of FastForward at the end of December. 101 Posting:

Analyzing Transactions Transactions 7: Payment of Salaries expenses in cash Analysis: - Assets (Cash) = – Equity (Expenses) Double entry: Debit Salaries Expenses and credit Cash Transaction 8: Provide services and rents test facilities for credit Analysis: + Assets (Accts Receivable) = + Equity (Revenues) Double entry: Debit Accounts Receivable and Credit Consulting Revenue and Credit Rental Revenue Transaction 9: Receipt of cash from accounts receivable Analysis: + Assets (Cash) = – Assets (Accounts Receivable) Double entry: Debit Cash and credit Accounts Receivable

Analyzing Transactions Transaction 10: Payment of accounts payable Analysis: – Assets (Cash) = – Liability (Accounts Payable) Double entry: Debit Accounts Payable and credit Cash Transaction 11: Payment of cash dividend Analysis: – Assets (Cash) = – Equity (Dividends) Double entry: Debit Dividends and credit Cash Transaction 12: Receipts of cash from a customer for future consulting services Analysis: + Assets (Cash) = + Liabilities (Unearned Revenue) Double entry: Debit Cash and credit Unearned Consulting Revenue

Analyzing Transactions Transaction 13: Pay cash for future insurance coverage Analysis: – Assets (Cash) = + Assets (Prepaid Insurance) Double entry: Debit Prepaid Insurance and credit Cash Transaction 14: Purchase supplies for cash Analysis: - Assets (Cash) = + Assets (Supplies) Double entry: Debit Supplies and credit Cash Transactions 15: Payment of utilities expenses in cash Analysis: – Assets (Cash) = – Equity (Expenses) Double entry: Debit Utilities Expense and credit Cash Transactions 16: Payment of salaries expenses in cash Double entry: Debit Salaries Expense and credit Cash

A1 After processing its remaining transactions for December, FastForward’s Trial Balance is prepared. Debits Credits Cash 4,350 $ Accounts receivable - Supplies 9,720 Prepaid Insurance 2,400 Equipment 26,000 Accounts payable 6,200 Unearned consulting revenue 3,000 Common stock 30,000 Dividends 200 Consulting revenue 5,800 Rental revenue 300 Salaries expense 1,400 Rent expense 1,000 Utilities expense 230 Total 45,300 FastForward Trial Balance December 31, 2009 The trial balance lists all account balances in the general ledger. If the books are in balance, the total debits will equal the total credits. On the trial balance we list all the account in our general ledger and their related balances. The total of all our debit account balances must equal all our credit account balances. If this is not the case, we may have made an error posting the journal entry into the ledger. We cannot prepare the financial statement until the books are in balance as determine by the trial balance.

Six Steps for Searching for and Correcting Errors If the trial balance does not balance, the error(s) must be found and corrected. Make sure the trial balance columns are correctly added. Recompute each account balance in the ledger. Make sure account balances are correctly entered from the ledger. Verify that each journal entry is posted correctly. You may want to refer back to this screen if you run into trouble with your homework. We have listed six steps to follow when your trial balance if out of balance. See if debit or credit accounts are mistakenly placed on the trial balance. Verify that each original journal entry has equal debits and credits.

Using a Trial Balance to Prepare Financial Statements Point in Time Point in Time Period of Time Income Statement Statement of Retained Earnings Statement of Cash Flows Beginning Balance Sheet Ending Balance Sheet As we have seen in the last chapter, after the trial balance has been prepared we begin preparing the financial statements. We always begin with the income statement because net income appears on the statement of retained earnings. After the income statement, we prepare the statement of retained earnings because the ending balance in retained earnings appears on the balance sheet. Next, we prepare the balance sheet and finally we prepare the statement of cash flows.

Income Statement P3 Here is the information for FastForward for the month ended December 31, 2009. The company had total revenues of sixty one hundred dollars and total expenses of two thousand six hundred and thirty dollars. For the month FastForward generated three thousand four hundred and seventy dollars in net income. Look back at our trial balance to verify the amount shown on the income statement.

Statement of Retained Earnings P3 The beginning balance in retained earnings was zero because the company was started on December 1, 2009. We earned income of three thousand four hundred and seventy dollars. During the month dividends of two hundred dollars were paid. The ending balance in retained earnings is three thousand two hundred seventy dollars. This amount will appear on the equity section of the balance sheet. Let’s look at the balance sheet now.

Balance Sheet P3 Total assets equal forty-two thousand four hundred seventy dollars. Total liabilities are ninety two hundred dollars and our equity balance is thirty-three thousand two hundred seventy dollars. The accounting equation is in balance because assets are equal to liabilities plus equity.