Chapter 2 Analyzing Business Transactions Skyline College

2–22–2 Copyright © Houghton Mifflin Company. All rights reserved. Measuring Transactions Economic Event Affects the financial position of an entity When to record? RecognitionValuation What value to record? Classification How to categorize?

2–32–3 Copyright © Houghton Mifflin Company. All rights reserved. When is a Recognized?  Recognition of a transaction refers to when it should be recorded  Point of recognition is important because it affects the financial statements For Products Recognize when title of property transfers For Services Recognize when services are performed If services are performed over a long period of time, bill at key points

2–42–4 Copyright © Houghton Mifflin Company. All rights reserved. At What Value Should a Transaction Be Recorded?  GAAP state that original cost (historical cost) be used to assign value  The cost principle is used because the exchange price can be verified by documentation (a cancelled check or an invoice) Check 334: Intelligent Designs $1,500 for computer Record at cost = $1,500 © Royalty Free C Squared Studios/ Getty Images

2–52–5 Copyright © Houghton Mifflin Company. All rights reserved. How Should a Transaction Be Classified?  Classification refers to assigning transactions to the proper accounts  Requires maintaining a system of accounts Able Co. purchases tools used for repairing manufacturing equipment. Classify as an expense OR Classify as equipment Affects net income (stockholders’ equity) Affects assets ©Comstock Klips

2–62–6 Copyright © Houghton Mifflin Company. All rights reserved. Ethics and Measurement Issues In the News – Violations of Measurement Guidelines WorldCom misclassifies expenditures: Understates expenses by more than $10 billion Xerox overstates revenues: Records lease revenues when leases signed rather than over lease term Enron overvalues assets: Investors and employees lose billions © Royalty-Free/Corbis

2–72–7 Copyright © Houghton Mifflin Company. All rights reserved. Discussion: Ethics on the Job Curt Winthrop, CFO for Tralcom Industries, decided to classify a purchase of small tools as an asset rather than an expense. In the past, such purchases have been classified as expenses, but the company needs the income statement to look strong for an upcoming loan application. Q. What do you think of Winthrop’s decision?

2–82–8 Copyright © Houghton Mifflin Company. All rights reserved. One Debit The Backbone of Accounting Based on the principle of duality – Every economic event has two aspects… In the double-entry accounting system, every transaction is recorded with at least… Effort AND Reward Sacrifice AND Benefit One Credit Debit totals must equal credit totals AND

2–92–9 Copyright © Houghton Mifflin Company. All rights reserved. Sacrifice Versus Benefit If you were to purchase a HD DVD player for $300, what is your sacrifice? What is your benefit? Sacrifice = $300 Benefit = DVD player © Royalty-Free/Corbis

2–10 Copyright © Houghton Mifflin Company. All rights reserved. Accounts  Basic storage units for accounting data  Used to accumulate amounts from similar transactions Categories of Accounts AssetsLiabilities Stockholders’ Equity Common Stock Retained Earnings + Revenues - Expenses - Dividends

2–11 Copyright © Houghton Mifflin Company. All rights reserved. The T Account The T account is a visual representation of an account Used to analyze transactions Title of Account Debit (left) side Credit (right) side Identifies the asset, liability, or stockholders’ equity account © Royalty Free C Squared Studios/ Getty Images

2–12 Copyright © Houghton Mifflin Company. All rights reserved. The Rules of Double-Entry Accounting Stockholders’ Assets = Liabilities + Equity Debit for Increases (+) Credit for Decreases (–) Remember that every transaction affects at least two accounts. At least one account is debited and one account is credited. One on the left and one on the right. Debit for Decreases (–) Credit for Increases (+) Credit for Increases (+) Debit for Decreases (–)

2–13 Copyright © Houghton Mifflin Company. All rights reserved. Stockholders’ Equity Accounts Retained Earnings Revenues Common Stock Dividends Expenses Increases to these accounts increase stockholders’ equity: These accounts are deductions from stockholders’ equity: – + + – + – + – – + © Royalty Free C Squared Studios/ Getty Images

2–14 Copyright © Houghton Mifflin Company. All rights reserved. Normal Balance of Account  The usual balance of an account Normal balance of asset, dividend, and expense accounts Normal balance of liability, common stock, retained earnings, and revenue accounts Account Debit side Credit side  The side (debit or credit) that increases an account

2–15 Copyright © Houghton Mifflin Company. All rights reserved. Accounts and the Accounting Equation Illustrated Stockholders’ Assets = Liabilities + Equity If a debit increases assets by $100, then a credit must increase stockholders’ equity or liabilities by $100 for the accounting equation to stay in balance = ___

2–16 Copyright © Houghton Mifflin Company. All rights reserved. Analyzing and Recording Transactions 1.Analyze the transaction to determine which accounts are affected. 2.Show the transaction in journal form. 3.Use T accounts to show how the transaction affects the accounting equation. © Royalty Free C Squared Studios/ Getty Images

2–17 Copyright © Houghton Mifflin Company. All rights reserved. Next: Record the entry in journal form Transaction: Owner’s Investment July 1: Pricilla Treadle invests $40,000 in Treadle Website Design, Inc. in exchange for 40,000 shares of $1 par value common stock. Cash Common Stock Stockholders’ Assets = Liabilities + Equity ,000

2–18 Copyright © Houghton Mifflin Company. All rights reserved. Transaction: Journal Form 2.Debit account and debit amount recorded on first line Cash 40,000 1.Date recorded on first line July 1 Recording the transaction in journal form: Cr. Dr. 3.Indent, credit account and credit amount recorded on second line Common Stock 40,000 © Royalty Free C Squared Studios/ Getty Images

2–19 Copyright © Houghton Mifflin Company. All rights reserved. + 3,200 Transaction: Prepayment of Rent July 3: Payment of 2 months rent in advance, $3,200 Cash Prepaid Rent Stockholders’ Assets = Liabilities + Equity + 40, ,200 This transaction simply trades one asset for another. The amount of total assets is not changed. -

2–20 Copyright © Houghton Mifflin Company. All rights reserved. Transaction: Journal Form Recording the transaction in journal form: 3,200 Cash 3,200Prepaid RentJuly 3 Cr. Dr. © Royalty Free PhotoDisc Collection/ Getty Images

2–21 Copyright © Houghton Mifflin Company. All rights reserved. Transaction: Purchase of Supplies on Credit July 5: Receipt of office supplies ordered on July 2 and an invoice for $5,200. Office SuppliesAccounts Payable Stockholders’ Assets = Liabilities + Equity + 5,200 July 5Office Supplies5,200 Accounts Payable5, ,

2–22 Copyright © Houghton Mifflin Company. All rights reserved. + 9,600 Transaction: Service Revenue July 15: Performs design services; bill now but to be received later, $9,600 Accounts ReceivableDesign Revenue Stockholders’ Assets = Liabilities + Equity + 9,600 July 15Accounts Receivable9,600 Design Revenue9,600 --

2–23 Copyright © Houghton Mifflin Company. All rights reserved. Preparing the Trial Balance  To ensure that total debits equal total credits, prepare a trial balance  Usually prepared on the last day of month 1.List accounts in the order in which they appear on the financial statements. 2.Put debit balances in the left column and credit balances in the right column 3.Add each column. 4. Compare the totals of the columns.

2–24 Copyright © Houghton Mifflin Company. All rights reserved. Trial Balance Record debit balances in left column Record credit balances in right column Total each column

2–25 Copyright © Houghton Mifflin Company. All rights reserved. Finding Trial Balance Errors If the debit and credit totals are not equal, look for one or more of these errors: A debit was entered as a credit, or vice versa The balance of an account was computed incorrectly An error was made in carrying the account balance to the trial balance The trial balance was summed incorrectly [photo] © Royalty-Free/Corbis

2–26 Copyright © Houghton Mifflin Company. All rights reserved. What Are the Most Common Trial Balance Errors? Recording a debit as a credit or vice versa Transposing two digits when transferring an amount to the trial balance Hint: The trial balance will be out of balance by an amount divisible by 2 Hint: The trial balance will be out of balance by an amount divisible by 9 © Royalty Free C Squared Studios/ Getty Images

2–27 Copyright © Houghton Mifflin Company. All rights reserved. Limitations of the Trial Balance Does not prove that transactions were analyzed correctly Does not determine whether amounts were recorded in the proper accounts [Photo] Does not detect whether transactions have been omitted © Royalty Free PhotoDisc Collection/ Getty Images

2–28 Copyright © Houghton Mifflin Company. All rights reserved. Cash Flows: Treadle Website Design, Inc. Cash Inv. by owner 40,000 3,200 Prepayment of rent 13,320 Purchase of equipment 2,600 Payment of liability Revenue 2,800 Advance revenue 1,400 Collection of A/R 5,0004,800 Payment of wages 2,800 Payment of dividends Treadle must ensure that it has adequate cash on hand at all times to pay its debts and maintain ongoing operations. Bal. 22,480 + _

2–29 Copyright © Houghton Mifflin Company. All rights reserved. Accounting System General Ledger 100 Account 101 Account 300 Account 301 Account 400 Account200 Account Chart of Accounts List of accounts and identifying numbers System of accounts grouped together manually or electronically © Royalty Free C Squared Studios/ Getty Images

2–30 Copyright © Houghton Mifflin Company. All rights reserved. Sample Chart of Accounts AssetsRevenues 100Cash401Service A 102Accounts Receivable402Service B 105Office Supplies403Service C 106Prepaid Rent 110Land LiabilitiesExpenses 200Accounts Payable501Wages Expense 201Notes Payable502Utilities Expense 204Wages Payable503Rent Expense 504Office Supplies Expense Stockholders’ Equity 505Income Taxes Expense 301Common Stock 305Retained Earnings 313Dividends 314Income Summary The first digit in each account number signifies its classification AssetsRevenues LiabilitiesExpenses Stockholders’ Equity

2–31 Copyright © Houghton Mifflin Company. All rights reserved. The General Journal Journalizing is the process of recording all transactions chronologically in a journal General Journal: Most flexible and simple

2–32 Copyright © Houghton Mifflin Company. All rights reserved. Journalizing a Transaction 1.The date 2.Names of accounts debited and dollar amounts on same line in debit column 3.Names of accounts credited (indented) and dollar amounts on same line in credit column 4.Explanation of transaction 5.Account identification numbers, if applicable July 6 Purchased cleaning supplies and office supplies on account Record:

2–33 Copyright © Houghton Mifflin Company. All rights reserved. The General Ledger  Used to record the details of each transaction  Used to update each account  In practice, the ledger account form is used © Royalty Free C Squared Studios/ Getty Images

2–34 Copyright © Houghton Mifflin Company. All rights reserved. Ledger Account Form Account title and number appear at top of account form The date appears in the first two columns (as in the journal) Item column is rarely used because explanations already appear in the journal Post. Ref. column used to note the journal page on which the original entry for the transaction can be found Dollar amount is entered in appropriate Debit or Credit column New account balance computed in the last two columns opposite each entry

2–35 Copyright © Houghton Mifflin Company. All rights reserved. Posting Transferring… Journal entry information transferred from the journal to the ledger Posting can be done daily, or less frequently depending on the number of transactions

2–36 Copyright © Houghton Mifflin Company. All rights reserved. Posting a Transaction 1.Locate debit account in the ledger 2.Enter date of transaction and journal page number in Post. Ref. column 3.Enter in Debit column amount of debit from journal 4.Calculate account balance and enter in appropriate Balance column 5.In journal Post. Ref. Column, enter account number to which amount was posted 6.Repeat for credit entry