1. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-1 CHAPTER 4 The Bookkeeping Process and Transaction Analysis McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

2. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-2 A = L + OE The Balance Sheet Equation—A Mechanical Key A = L + PIC + RE BEG + R - E The basic accounting equation can be expanded to include revenues and expenses. L O 1

3. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-3 Let’s see how some transactions effect the operation of this equation. L O 2 The Balance Sheet Equation

4. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-4 Transactions a.The owners invested $2,000. b.The company borrowed $6,000 from a bank. c.Equipment costing $10,000 was purchased for $2,000 cash and signing a note payable for $8,000. d.Equipment that cost $3,000 was sold for $3,000. The $3,000 will be received within 30 days. e.The company provided services for $8,000 and received cash. f.Wages of $2,000 were paid in cash. L O 2 The Balance Sheet Equation

5. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-5 L O 3 The Balance Sheet Equation

6. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-6 Bookkeeping Jargon Transactions are initially recorded in a journal. Cash Equipment Inventory Notes Payable Transactions are then recorded— posted to—individual accounts in the ledger. L O 4 Accounts are used to organize or group transactions to facilitate financial statement preparation.

7. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-7 A T-account is a tool used to represent an account. Account Name LeftRight T-Account L O 4

8. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-8 T-Account The left side of the T-account is always the debit side. Account Name Left Right Debit The right side of the T-account is always the credit side. Credit L O 4

9. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-9 Debits and CreditsASSETS Debit for Increase Credit for DecreaseEQUITIES Debit for Decrease Credit for IncreaseLIABILITIES Debit for Decrease Credit for Increase Debits and credits affect the accounting equation as follows: A = L + OE L O 4

10. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-10 Debits and Credits ASSETS Debit for Increase Credit for Decrease EQUITIES Debit for Decrease Credit for Increase LIABILITIES Debit for Decrease Credit for Increase A = L + OE Paid-in capital Retained earnings Remember that owners’ equity includes paid-in capital and retained earnings. L O 4

11. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-11 Revenue and Expenses Increases in owners’ equity. Increase with a credit. Decreases in owners’ equity. Increase with a debit. L O 4

12. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-12 Debits and Credits A = L + OE L O 5

13. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-13 Journal Entry Format A typical journal entry might look like this. L O 5

14. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-14 Journal Entry Format Provide a reference date for each transaction. Debits are recorded first. Credits are indented and recorded after debits. Total debits must equal total credits. L O 5 A brief description of the transaction to explain the entry

15. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-15 The Bookkeeping Process Recorded in the Journal Account Name Debit Credit Posted to the Ledger Transactions Source Documents L O 5

16. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-16 Transaction Analysis Illustrated Let’s prepare some journal entries and post them to the ledger. Transactions (All transactions pertain to the current year) a.On January 1, the owners invested $2,000. b.On January 15, the company borrowed $6,000 from a bank. c.On February 1, equipment costing $10,000 was purchased for $2,000 cash and signing a note payable for $8,000. d.On February 15, equipment that cost $3,000 was sold for $3,000. The $3,000 will be received within 30 days. e.On February 20, the company provided services for $8,000 and received cash. f.On February 25, wages of $2,000 were paid in cash. L O 6

17. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-17 The owners invested $2,000. L O 6 Transaction Analysis Illustrated

18. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-18 The company borrowed $6,000 from a bank. L O 6 Transaction Analysis Illustrated

19. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-19 Let’s see how to post this entry... Equipment costing $10,000 was purchased for $2,000 cash and signing a note payable for $8,000. L O 6 Transaction Analysis Illustrated

20. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-20 Equipment costing $10,000 was purchased for $2,000 cash and signing a note payable for $8,000. L O 6 Transaction Analysis Illustrated

21. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-21 Equipment that cost $3,000 was sold for $3,000. The $3,000 will be received within 30 days. L O 6 Transaction Analysis Illustrated

22. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-22 The company provided services for $8,000 and received cash. L O 6 Transaction Analysis Illustrated

23. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-23 Wages of $2,000 were paid in cash. L O 6 Transaction Analysis Illustrated

24. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-24 At the end of the period, we need to make adjusting entries to bring the accounts up to date for the financial statements. L O 6 Adjustments/Adjusting Entries

25. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-25 Types of Adjusting Entries The initial recording of a transaction does not result in assigning revenues to the period in which they were earned or expenses to the period in which they were incurred. Transactions for which cash has NOT yet been received or paid, but the effect of which must be recorded in the accounts in order to accomplish a matching of revenues and expenses. Reclassifications Accruals L O 6

26. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-26 Adjusting entries are needed whenever revenue or expenses affect more than one accounting period. Every adjusting entry involves a change in either a revenue or expense and an asset or liability. Adjustments/Adjusting Entries L O 6 Adjusting entries Reclassifications) occur at the end of the accounting period. (Accruals and

27. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-27 Examples Include: Wages and Salaries Interest Payable Property Taxes Hey, when do we get paid? Accruing Expenses L O 6

28. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-28 Monday, May 29 Friday, June 2 $3,000 Wages Expense On May 31, Webb Co. owes wages of $3,000. Pay day is Friday, June 2. Wednesday, May 31 Accruing Expenses L O 6

29. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-29 Initially, an expense and a liability are recorded. Accruing Expenses L O 6 May 29 $3,000 Wages Expense May 31

30. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-30 Income Statement Cost incurred this period to generate revenue. Income Statement Cost incurred this period to generate revenue. Balance Sheet Liability to be paid in a future period. Balance Sheet Liability to be paid in a future period. Accruing Unpaid Expenses L O 6

31. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-31 Monday, May 29 Friday, June 2 $5,000 Weekly Wages Let’s look at the entry for June 2. Wednesday, May 31 $2,000 Wages Expense $3,000 Wages Expense Accruing Expenses L O 6

32. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-32 The liability for May wages is reduced when the debt is paid. Accruing Expenses L O 6

33. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-33 Examples Include: Interest Earned Work Completed But Not Yet Billed to Customer Accruing Revenues L O 6

34. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-34 Saturday, Jan. 15 Tuesday, Feb. 15 $170 Interest Revenue On Jan. 31, the bank owes Webb Co. interest of $170. Interest is paid on the 15 th day of each month. Monday, Jan. 31 Accruing Revenues L O 6

35. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-35 Initially, the revenue is recognized and a receivable is created. Accruing Revenues L O 6

36. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-36 Income Statement Revenue earned this period. Income Statement Revenue earned this period. Balance Sheet Receivable to be collected in a future period. Balance Sheet Receivable to be collected in a future period. Accruing Revenues L O 6

37. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-37 Saturday, Jan. 15 Tuesday, Feb. 15 $320 Monthly Interest $170 Interest Revenue Let’s look at the entry for February 15th. Monday, Jan. 31 $150 Interest Revenue Accruing Revenues L O 6

38. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-38 The receivable is collected in a future period. Accruing Revenues L O 6

39. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-39 Expiring Insurance Policies: Prepaid Insurance Insurance Expense Supplies Supplies Expense End of month adjusting entries L O 6 AssetsExpenses Reclassifying Assets to Expenses

40. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-40 Jan. 1Dec. 31 $2,400 Insurance Policy Coverage for 12 Months $200 Monthly Insurance Expense On January 1, Webb Co. purchased a one- year insurance policy for $2,400. Reclassifying Assets to Expenses L O 6

41. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-41 Initially, costs that benefit more than one accounting period are recorded as assets. Reclassifying Assets to Expenses L O 6

42. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-42 The costs are expensed as they are used to generate revenue. Reclassifying Assets to Expenses L O 6

43. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-43 Income Statement Cost of assets used this period to generate revenue. Income Statement Cost of assets used this period to generate revenue. Balance Sheet Cost of assets that benefit future periods. Balance Sheet Cost of assets that benefit future periods. Reclassifying Assets to Expenses L O 6

44. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-44 Unearned Revenue Revenue Unearned Rental Revenue Rental Revenue Airline Ticket Advanced Sales Ticket Revenue End of month adjusting entries L O 6 Liabilities Revenues Reclassify Liabilities to Revenues

45. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-45 Jan. 1Dec. 31 $6,000 Rental Contract Coverage for 12 Months $500 Monthly Rental Revenue On January 1, Webb Co. received $6,000 in advance for a one-year rental contract. Reclassifying Liabilities to Revenues L O 6

46. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-46 Initially, revenues that benefit more than one accounting period are recorded as a liability. Reclassifying Liabilities to Revenues L O 6

47. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-47 Over time, the revenue is recognized as it is earned. Reclassifying Liabilities to Revenues L O 6

48. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-48 Income Statement Revenue earned this period. Income Statement Revenue earned this period. Balance Sheet Liability for future periods. Balance Sheet Liability for future periods. Reclassifying Liabilities to Revenues L O 6

49. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-49 Closing the Books L O 6 The closing process simply transfers the year-end balances of all income statement accounts (e.g., revenues, expenses, gains and losses) to the retained earnings account. In addition, the dividends account is also closed to retained earnings. This process creates zero balances in the revenue, expense and dividend accounts, thereby making them ready for the transactions of the next period.

50. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-50 Closing Entries Revenues and gains increase retained earnings Expenses, losses and dividends decrease retained earnings L O 6

51. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-51 Transaction Analysis Methodology Answer Five Questions: 1.What’s going on? 2.What accounts are affected? 3.How are they affected? 4.Does the balance sheet balance? (Do the debits equal the credits?) 5.Does my analysis make sense? L O 7

52. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 4-52 End of Chapter 4