Chapter 2. Analyzing transactions

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Chapter 2

Analyzing transactions

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1. Explain the steps in the accounting cycle and each step’s supporting documentation

2. Explain the purpose of source documents 3. Describe an account and its purpose

4. Describe a chart of accounts

5. Define debits, credits and account balance

6. Explain the rules of debits and credits in double- entry accounting and the normal balance of an account

Learning objectives

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7. Transaction analysis – debits and credits

8. Prepare a trial balance and explain its purpose in the accounting cycle

9. Prepare financial statements from the trial balance

Learning objectives

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Explain the steps in the

accounting cycle and each step’s

supporting documentation

Learning objective 1

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▪ Steps and procedures that accountants follow when recording accounting information

▪ Performing the same steps each cycle helps minimize errors when recording transactions

The accounting cycle

Step in the accounting cycle Documentation

1. Analyze transactions Source documents

2. Journalize transactions General journal

3. Post transactions from the journal to the ledger General ledger

4. Prepare a trial balance Trial balance

5. Prepare the financial statements Financial statements

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Explain the purpose of

source documents

Learning objective 2

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Source documents

– Invoice

– Purchase order – Checks

– Bank statement – Cash register tape – Employee records

▪ Step one in the accounting cycle is to analyze transactions from source documents

▪ A source document is a record that provides written evidence that a transaction has occurred

▪ Used to record the transaction Examples:

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Describe an account

and its purpose

Learning objective 3

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▪ After analyzing the transaction from the source document we record it in the accounting records

▪ But what are these accounting records?

▪ Accounts!

The account

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▪ An account is a record that documents increases and decreases in specific items

▪ These items are classified as:

– Assets – Liabilities – Equity

– Revenues – Expenses

▪ Accounts are used because they are an efficient

The account

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The account

– Cash

– Accounts Receivable

– Accounts Payable – Capital

▪ Chapter 1 introduced us to some specific accounts:

▪ New accounts introduced in this chapter:

– Prepaid Expenses (Asset account)

– Unearned Revenue (Liability account)

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Describe a

chart of accounts

Learning objective 4

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▪ How do we know what accounts are used by a business?

Chart of accounts:

– List of all of the accounts used by the business

– Displays account name and account number for each account

– Used to keep track of the accounts held by the business

▪ What does a chart of accounts look like?

Chart of accounts

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Chart of accounts - example

Account No. Account Name 100 Cash

110 Accounts Receivable 130 Supplies

160 Equipment

210 Accounts Payable 230 Unearned Revenue 250 Loan Payable

300 Capital

350 Withdrawals 400 Revenues

541 Advertising Expense

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Define debits, credits

and account balance

Learning objective 5

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▪ We know that transactions are recorded in accounts

▪ But how they are recorded in the accounts?

▪ Transactions are recorded using debits and credits

▪ But what does debit and credit mean?

Debits and credits

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Debit = Left

Credit = Right

▪ Debits and credits do not mean:

– Good or bad

– Favorable or unfavorable – Increase or decrease

• Whether debits or credits refer to an increase or decrease depends on the classification of each account

Debits and credits

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▪ We can see debits and credits using the T-account:

▪ To debit an account is to record an entry on the left

▪ To credit an account is to record an entry on the right

T-account

Account Title Debit Credit

Dr Cr

Left side Right side

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▪ As well as a debit and a credit side, an account has an account balance

▪ An account balance is the difference between total debits and total credits recorded in that account

– Debit balance: Dr > Cr – Credit balance: Dr < Cr

▪ How do we calculate the account balance?

Account balance

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Example using a simple T-account:

▪ The Cash account has a debit balance of $7,000

▪ There are other formats an account may take

Calculating an account balance

Cash No. 100

(debits) 3,000 (credits) 1,000 5,000

Balance 7,000

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An example of a more detailed T-account:

Account formats: T-account

Cash No.100

Dec. 1 Capital 2,000 Dec. 2 Supplies 700

5 Loan Payable 5,000 4 Accounts Payable 600

6 Revenues 3,300 9 Expenses 150

8 Accounts Receivable 800 10 Withdrawals 250

Balance 9,400

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The same account - running balance format:

Account formats: Running balance format

Cash No. 100

Date Description Ref. Debit Credit Balance

2011

Dec. 1 Balance 0

1 Cash investment by owner 2,000 2,000 Dr

2 Purchase stationery with cash 700 1,300 Dr

4 Partial payment for credit purchase 600 700 Dr

5 Received bank loan 5,000 5,700 Dr

6 Performed services for cash 3,300 9,000 Dr

8 Received cash from Accounts Receivable 800 9,800 Dr

9 Paid expense with cash 150 9,650 Dr

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Explain the rules of debits and

credits in double-entry accounting

and the

normal balance of an account

Learning objective 6

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▪ We use debits and credits in double-entry accounting to record transactions

▪ The rules of double-entry accounting are:

– Each transaction affects at least two accounts

– Each transaction has at least one debit and one credit – Total debits must equal total credits

– The accounting equation must always remain in balance

Assets = Liabilities + Equity

Double-entry accounting

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▪ This leads us to the general rules of debits and credits used in double-entry accounting

– Assets are increased by debits (decreased by credits)

– Liabilities and equity are increased by credits (decreased by debits)

Rules of debits and credits

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▪ These general rules are extended to the

components of the expanded accounting equation:

– Capital is increased by credits (decreased by debits)

– Withdrawals is increased by debits (decreased by credits) – Revenues are increased by credits (decreased by debits) – Expenses are increased by debits (decreased by credits)

Rules of debits and credits

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▪ To help us remember the rules of debits and credits, we can think of the normal balance of an account:

– the debit or credit side of the account to which increases are recorded

Normal balance of an account

Account classification: Normal balance:

Asset Debit

Liabilities Credit

Capital Credit

Withdrawals Debit

Revenues Credit

Expenses Debit

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Transaction analysis –

debits and credits

Learning objective 7

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▪ Recall the first step in the accounting cycle was to analyze transactions from source documents

▪ We can now use debits and credits to perform the second step, journalize transactions

▪ But what does journalize transactions mean?

Transaction analysis - debits and credits

2. Journalize transactions General journal

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Journalizing:

▪ the process of recording a transaction in a journal Journal:

▪ A record in which the transactions of the business are entered (or journalized)

– Like a diary that records the transactions in chronological order

▪ Once a transaction has been journalized, the

individual transaction is known as a journal entry

Journalizing transactions

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▪ Transactions are recorded in the general journal:

▪ For each transaction, we record the:

– Date

– Accounts debited and credited – Value of the transaction

General journal

General journal GJ-1

Date Account and explanation Post

Ref. Debit Credit

2011

Dec. 1 Cash 2,000

Capital 2,000

(Cash investment by owner.)

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▪ Once transactions have been journalized, the next step in the accounting cycle is to post them to the general ledger

Posting to the ledger

3. Post transactions from the journal to the ledger General ledger

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General ledger:

▪ A record that contains all accounts of the business

Posting:

▪ The process of transferring information from journals to ledger accounts

▪ Let’s look at an illustration of how this is done

Posting to the ledger

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Posting from the journal to the ledger

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▪ Now we know how to journalize transactions in the general journal and post them to the ledger, we can look at how to record specific transactions

▪ The general steps for recording all transactions are:

– Recognize the transaction to be recorded

– Analyze the transaction using the accounting equation

– Determine which accounts are to be debited and credited – Journalize the transaction

– Post the transaction to the ledger

Illustration of transaction analysis

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A. Owner invests $2,000 cash into the business

Journal entry:

Ledger posting (T-accounts):

A. Cash investment by owner

Cash No. 100 (A) 2,000

Capital No. 300 (A) 2,000

Ref. Debit Credit 2011

Dec. 1 Cash 100 2,000

Capital 300 2,000

(Cash investment by owner.)

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B. Purchased supplies for $700 cash

Journal entry:

B. Purchased an asset with cash

Cash No. 100 (B) 700

Supplies No. 130 (B) 700

Dec. 2 Supplies 130 700

Cash 100 700

(Purchased supplies with cash.)

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C. Purchased a laptop computer on credit for $2,400

Journal entry:

C. Purchased an asset on credit

Equipment No. 160 (C) 2,400

Accounts Payable No. 210 (C) 2,400

Dec. 3 Equipment 160 2,400

Accounts Payable 210 2,400

(Purchased computer on credit.)

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D. Paid $600 cash toward previous credit purchase

Journal entry:

D. Paid for an asset purchased on credit

Cash No. 100 (D) 600

Accounts Payable No. 210 (D) 600

Dec. 4 Accounts Payable 210 600

Cash 100 600

(Partial payment for asset purchased on credit.)

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E. Received a loan of $5,000 from the bank

Journal entry:

E. Received loan

Cash No. 100 (E) 5,000

Loan Payable No. 250 (E) 5,000

Dec. 5 Cash 100 5,000

Loan Payable 250 5,000

(Received cash loan from bank.)

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F. Performed tutoring services for $3,300 cash

Journal entry:

F. Performed services for cash

Cash No. 100 (F) 3,300

Revenues No. 400 (F) 3,300

Dec. 6 Cash 100 3,300

Revenues 400 3,300

(Received cash for services performed.)

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G. Performed $4,400 worth of services on credit

Journal entry:

G. Performed services on credit

Accounts Receivable No. 110 (G) 4,400

Revenues No. 400 (G) 4,400

Dec. 7 Accounts Receivable 110 4,400

Revenues 400 4,400

(Performed services on credit.)

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H. Received $800 cash from credit customers

Journal entry:

H. Received cash from Accounts Receivable

Cash No. 100 (H) 800

Accounts Receivable No. 110 (H) 800

Dec. 8 Cash 100 800

Accounts Receivable 110 800

(Received cash from credit customers.)

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I. Paid $150 cash for advertising campaign

Journal entry:

I. Paid expense with cash

Cash No. 100 (I) 150

Advertising Expense No. 541 (I) 150

Dec. 9 Advertising Expense 541 150

Cash 100 150

(Paid cash for advertising expense.)

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J. Owner withdraws $250 cash from the business

Journal entry:

J. Owner withdraws cash from business

Cash No. 100 (J) 250

Withdrawals No. 350 (J) 250

Dec. 10 Withdrawals 350 250

Cash 100 250

(Cash withdrawal by owner.)

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K. Signing an employment agreement

Journal entry:

▪ No journal entry required because there is no change to the value of the assets, liabilities, equity, revenues or expenses of the business

K. Non business transaction

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L. Paid $360 for a 3 year insurance premium

Journal entry:

L. Prepaid expense

Cash No. 100 (L) 360

Prepaid Insurance No. 142 (L) 360

Dec. 12 Prepaid Insurance 142 360

Cash 100 360

(Paid for 36 month insurance policy for the computer.)

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M. Made a loan repayment of $500

Journal entry:

M. Repayment of loan

Cash No. 100 (M) 500

Loan Payable No. 250 (M) 500

Dec. 13 Loan Payable 250 500

Cash 100 500

(Repaid part of the principal of the bank loan.)

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N. Received $900 cash in advance for tutoring

Journal entry:

N. Unearned revenue

Cash No. 100 (N) 900

Unearned Revenue No. 230 (N) 900

Dec. 14 Cash 100 900

Unearned Revenue 230 900

(Received revenue in advance.)

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O. Performed $2,000 worth of tutoring services.

$450 was received in cash with the remaining

$1,550 to be received on credit

Journal entry:

▪

O. Compound journal entry

Dec. 15 Cash 100 450

Accounts Receivable 110 1,550

Revenues 400 2,000

(Performed services for cash and credit.)

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Prepare a trial balance and

explain its purpose in the

accounting cycle

Learning objective 8

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▪ After journalizing transactions and posting them to the ledger, the next stage in the accounting cycle is to prepare a trial balance

Trial balance

4. Prepare a trial balance Trial balance

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▪ The trial balance is a list of all general ledger

accounts held by the business and their balances at a specific point in time

▪ Purpose is to verify that total debits equals total credits in the accounts

Trial balance

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Trial balance - example

Running Latte Trial Balance December 31, 2011

No. Account Debit

$ Credit

$

100 Cash 9,890

110 Accounts Receivable 5,150

130 Supplies 700

142 Prepaid Insurance 360

160 Equipment 2,400

210 Accounts Payable 1,800

230 Unearned Revenue 900

250 Loan Payable 4,500

300 Capital 2,000

350 Withdrawals 250

400 Revenues 9,700

541 Advertising Expense 150

Totals 18,900 18,900

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▪ Use the general ledger to construct the trial balance

– List account numbers and account names

– Transfer debit and credit balances into corresponding column

– Calculate total debits and credits

– Verify total debits equals total credits

▪ The trial balance is said to be balanced when total debits equals total credits

▪ But what if the trial balance does not balance?

Preparing a trial balance

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▪ Add up the columns again and check:

▪ Is an account missing?

– Look for difference between debits and credits in the ledger

▪ Debits or credits recorded in wrong column?

– Difference ÷ 2

▪ Transposition or slide error?

– Difference ÷ 9

Trial balance errors

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▪ There are 2 main ways to correct an error in the accounts

▪ Rule a line through the entry and enter the correct information for:

– Incorrect journal entry that has not been posted

– Posting an incorrect amount to the correct ledger account

▪ Journalize a correcting entry for:

– Incorrect journal entry that has been posted – Journal entry posted to the wrong account

Correcting errors in the accounts

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▪ A balanced trial balance can not guarantee the accounts are free from errors

▪ The following errors may still exist in the accounts:

– Missing transactions that were not journalized or posted – Duplicate transactions where journal entries were

recorded or posted more than once

– Incorrect accounts that have been used in journalizing or posting

– Incorrect dollar amounts that have been journalized or posted to the correct account

Limitations of the trial balance

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Prepare financial statements

from the trial balance

Learning objective 9

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▪ Once the trial balance is balanced, we can use it to help prepare the financial statements

Financial statements

4. Prepare a trial balance Trial balance

5. Prepare the financial statements Financial statements

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▪ The trial balance can be used to help construct the financial statements

▪ The order of the accounts in the trial balance is generally the order in which they appear in the financial statements

– balance sheet accounts are at the top of the trial balance – income statement accounts are at the bottom of the trial

balance