1. Accounting for Transactions and the Financial Statements
Chapter 2
Accounting for Transactions and the Financial Statements
Q: How does a bank determine is a business is qualified to receive a loan? How does a bonding company determine if a construction company is stable enough for bonding? How does an educated investor analyze a company to determine if it’s under valued?
A: All of the above questions have the same answer…..to evaluate the financial stability of a business, one would look at the financial statements of the company which are prepared or certified by Financial Accountants.
There are four (book defines 3) primary types of financial statements that get prepared together as a package for evaluation by interested outside parties:

2. Financial Statements P1
Let’s prepare the Financial Statements reflecting the transactions we have recorded.
Income Statement
Statement of Retained Earnings
Balance Sheet
Statement of Cash Flows
There are four fundamental financial statements used in accounting.
1. The income statement shows our revenues and expenses.
2. The statement of owner’s equity shows the change in the owners’ equity during the current period.
3. The balance sheet is a listing of all asset, liability, and equity account balances.
4. The statement of cash flows shows where the company got its cash and how it spent its cash.
The first financial statement that we prepare is the income statement. Let’s get started. 34

3. Net income is the difference between Revenues and Expenses.
Income Statement P1
Net income is the difference between Revenues and Expenses.
Net income is defined as the difference between revenues and expenses. If expenses exceed revenues, we have a net loss rather than net income. Financial statements have a three line title with the company name, the name of the statement, and the period covered by the report. In our case, we had total revenues of three thousand dollars and total expenses of eight hundred dollars, so net income for the month ended December 31, 2007, was two thousand, two hundred dollars. After completing the income statement, we may prepare the statement of retained earnings.
-Income Statement (Statement of Earnings)- The amount of income A/K/A Revenues less expenses for a particular period of time. (Page 66 in text and last page of notes).
The income statement describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.

4. Statement of Retained EarningsP1
The net income of $2,200 increases Retained Earnings by $2,200.
-Statement of Retained Earnings- summarizes the change in retained earnings over a period of time. This statement is usually consolidated with and shown at the bottom of the income statement. (page 66 in text and last page of notes
In the statement of retained earnings, we start with the balance at the beginning of the period, add net income earned during the period, and deduct any dividends paid, resulting in the ending balance in retained earnings. The company was started this month, so the beginning balance in retained earnings was zero. During December net income of two thousand, two hundred dollars was earned. In addition, five hundred dollars in dividends was paid, so the ending balance in retained earnings is one thousand, seven hundred dollars. After we complete this statement, we can prepare the balance sheet.

5. Balance Sheet P1
The Balance Sheet describes a company’s financial position at a point in time.
-Balance Sheet (Statement of Financial Position)- a “snapshot” of a company that summarizes the total assets, liabilities and equity of a company as of a particular date. (Page 66 text and last page of notes). These can be prepared at the end of a year, month or quarter or as of any period.
The balance sheet is an inventory of assets, liabilities and equity at the end of the month. Our total assets are equal to twenty six thousand, nine hundred dollars. This includes cash of ninety seven hundred dollars, supplies of twelve hundred dollars, and equipment of sixteen thousand dollars.
Liabilities include accounts payable of twelve hundred dollars and notes payable of four thousand dollars. The common stock account has a balance of twenty thousand dollars and we just calculated the ending balance in retained earnings of seventeen hundred dollars. You can see that the books are in balance because total assets are equal to total liabilities plus equity.
Creditors have claims against our assets of five thousand, two hundred dollars. The owner has claims to assets of twenty one thousand, seven hundred dollars.

6. Statement of Cash FlowsP1
We will cover the statement of cash flows in detail in a later chapter. Notice that the statement is divided into three major sections; (1) cash flows from operating activities; (2) cash flows from investing activities; and (3) cash flows from financing activities. The statement reconciles to the ending cash balance of nine thousand, seven hundred dollars.
Now that we’ve summarized the basic financial statements, lets discuss the basic elements of each statement.

7. 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.
Assets- something that you own
What financial statements are these found on??
Prepaid Accounts
Equipment
Supplies

8. Liability Accounts Liability Accounts Accounts Payable Notes Payable
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.
Liabilities- something that you owe
What Financial Statement are they found on?
Unearned Revenue
Accrued Liabilities

9. Equity Accounts Equity Accounts Common Stock Dividends Revenues
Owners equity- the owners actual interest in the business, is determined by subtracting total assets from total liabilities. Otherwise known as net assets or stockholders equity. Many people refer to owners equity as the residual interest in the business.
What financial statements are the above found on??
Note DIAGRAM on Blackboard to illustrate equity, revenue and expense!!
Financial statement terminology relating to the income statement and statement of retained earnings:
Revenues- Increase in company resources from the sale of goods or services. If I sell 10 Pepsi’s in a bar for $3 a can, I have $30 in revenue.
Expenses- costs incurred in the normal course of business to generate these revenues. The bars cost to buy the bottles of pepsi, and salaries to the bartenders are examples.
Net Income- an overall measure of performance for the period which equals revenues less expenses.
Ending retained earnings is: Beginning Retained Earnings + Net Income – Dividends Paid = Ending Retained Earnings.
Statements tie in and are all inter related, see page 66 in textbook, and handout on overhead.
Revenues
Expenses

10. = + Accounting Equation Liabilities Equity Assets Liabilities & Equity
The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because in a general way it states that assets must be equal to the claims against those assets. If you have an asset we can have two broad categories of claims against that asset. First, we may have claims by creditors, liabilities. Finally, after all creditor claims are satisfied, the residual owners, and stockholders, have a claim on those assets.
Liabilities & Equity
Assets

11. Expanded Accounting Equation
Liabilities
Equity
Assets = +
Liabilities
Equity
Assets = +
Revenues
Expenses
Common Stock
Dividends _ +
Here is a breakdown of the equity section of the of the accounting equation to show the mathematical signs we will be using to keep track of investments by owners, common stock, payments to owners (dividends), revenues and expenses. Notice that revenues increase equity and expenses reduce equity.
Retained Earnings

12. Transaction Analysis Equation
The accounting equation MUST remain in balance after each transaction.
Liabilities
Equity
Assets = +
During the process of recording business transactions, it is important that we always keep the accounting equation in balance. We can’t let our books get out of balance. You have probably heard this term before, but may not have been sure what we meant by keeping the books in balance.

13. Analyzing and Recording Process
Record relevant transactions and events in a journal
Analyze each transaction and event form source documents
Post journal information to ledger accounts
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.
Analyzing and Processing Transactions:
Throughout the year, as transactions occur for a business, the individual transactions are recorded. The ends of the year financial statements are a summary of all the transactions that occur during the year. The general “bookkeeping” process is recording of the day-to-day transactions, while the process of “accounting” is summarizing these day to day transactions in the financial statements.
In order to account for the large volume of transactions that an entity may have, take McDonalds for example, accountants have devised a process to account for transactions of an entity and named this process the Accounting Cycle the procedure for analyzing, recording, summarizing, and reporting the transactions of a business.
Prepare and analyze the trial balance

14. 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.

15. 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

16. 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.

17. The Account and its Analysis
Assets Accounts = +
Liability Accounts
Equity Accounts
At all times, assets must always equal liabilities plus owners equity, therefore if an event occurs that increases assets, something must change to either liabilities or owners equity, so that the equation is always equal. This is the concept behind double entry accounting a system of recording transactions in a way that maintains the equality of the accounting equation.
What is the effect of each transaction on the accounting equation?
Investment of $50,000 capital by owners of the business.
Company borrowed a $25,000 note from the bank.
Company purchased $14,000 worth of inventory on credit to be paid at a later date.
Company purchased equipment costing $15,000. Was purchased for cash.
You should notice that in each case, the total net effect on the accounting equation is zero, or assets still equal liabilities + owners equity.

18. 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. Instead of just recording transactions to general assets, liability or equity accounts, we create actual accounts as shown above, and record to specific accounts. Accounts that begin with a #1 are assets, #2 are liabilities, #3 equity, # 4 revenue and #5 expense.

19. 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.
To obtain an understanding of an account we often analyze accounts in a T-account a simplified deception of an account in the form of a letter T. The account is a specific record used to track, classify and monitor transactions. The “T” Account is the ledger function of the accounting function as shown above. After one records the transactions into the Journal to be described next, the transactions are then posted to “T” Accounts.
The left side of a T-Account is called the debit side and the right side is called the credit side of the account. Just like assets always must equal liabilities plus equity, debits must always equal credits; therefore if you debit one account for $100, you must also credit another account for $100.
Look at the examples below that we previously discussed and record each transaction in a “T” account
1. Investment of $50,000 capital by owners of the business.
2. Company borrowed a $25,000 note from the bank.
3. Company purchased $14,000 worth of inventory on credit to be paid at a later date.
4. Company purchased equipment costing $15,000. Was purchased for cash.
Notice in each case that for each transaction one account has a ‘debit’ and one account has a ‘credit’ for each transaction. Also be aware that per double entry accounting each transaction must have a MININUM of two accounts impacted, but there is no upper limit, e.g. a payroll journal entry for a large company could impact literally thousands of accounts.

20. Double-Entry Accounting
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.

21. 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

22. Journalizing TransactionsP1
Journalizing Transactions
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, 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.
Take the transactions that we have currently used with the accounting equation and ‘T’ accounts and now record them in journal entries.
Dollar amount of debits and credits
Transaction explanation

23. 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.
In this course, we will utilize ‘T’ Accounts as the ledger, so if asked on a quiz or exam to post a transaction, this means to post all transactions from the journal to ‘T’ Accounts.
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:

24. 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:

25. 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:

26. 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:

27. 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:

28. 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, 2007
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.
Each account has a normal balance or balance that an account should generally have. In other words, any asset’s normal balance is a debit balance, while liabilities and equity normally have a credit balance. To increase an asset, you would debit it, and it normally has a debit balance, while to increase a liability or equity one would credit it, meaning that its normal balance is a credit balance.
Assets = Liabilities + Owners Equity
Since assets are on the LEFT side of the equal sign, they are considered DEBIT accounts, are increased with a debit and shown on the debit side of the trial balance. Since Liabilities and Equity are on the right (Credit) side of the equation, they are credit accounts and increased with a credit.
Why are revenues credit accounts and expenses debit accounts?

29. 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 trail 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.

30. Income Statement P3
Here is the information for FastForward for the month ended December 31, 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.

31. Statement of Retained EarningsP3
The beginning balance in retained earnings was zero because the company was started on December 1, 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.

32. 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.
The last two pages are summarized together on page 66 of your textbook.