Do you spend hours looking for messages that you got just a couple

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1 CHAPTER 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet Understand what a balance sheet means to users. LO1 Explain and select common balance sheet account titles. Study how to analyze transactions. LO2 Apply transaction analysis to business transactions. Evaluate transactions using the debit/credit framework. LO3 Use journal entries and T-accounts to show how business transactions affect the balance sheet. LO4 Prepare an unadjusted trial balance and a balance sheet. Reconsider the balance sheet concepts that users rely on. LO5 Explain the concepts that determine whether an item is reported on the balance sheet and at what amount. OUTSIDE LOOKING IN INSIDE LOOKING OUT This chapter introduces the system of accounting, which gathers financial information and produces the balance sheet as well as the other financial statement reports. We focus on the investing and financing activities of First Choice Haircutters, Canada s dominant value-priced hair salon chain. Do you spend hours looking for messages that you got just a couple of weeks ago? Have you ever found the perfect Web site, only to later misplace your bookmark to it? Does your directory of file folders contain meaningless labels like stuff? If so, you probably could use an organizing system that neatly sorts every , bookmark, and file into categories. With such a system, you might be able to quickly find that funny joke about the magician and the parrot, or the stats assignment that is due tomorrow. Businesses also need systems for organizing information. Just think what could happen if a system didn t exist to track the millions of letters and packages handled by Canada Post every day, or the millions of phone calls at Bell Canada. Clearly, big companies need well-organized systems for tracking their business activities and financial results. But it s not just the big guys who need accounting systems. Small businesses, like your local FIRST CHOICE HAIRCUTTERS (FCH) salon, need them too. In this chapter, we ll focus on the decisions that business managers make when starting up a single FCH salon and how their accounting systems track the financial results of the salon s investing and financing activities. In later chapters, you ll see how things are basically the same, only bigger, at Regis Corporation a public company that bought First Choice Haircutters in 2000 and now owns over 12,000 salons worldwide, making Regis eight times the size of its closest competitor.

2 42 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet You may remember our promise in Chapter 1 that you d have time to learn the details about specific financial statement accounts in Chapters 2 through 4. That time has come: We begin this chapter with a look at the balance sheet and its accounts. This is a good place to start because the balance sheet is based on the basic accounting equation, which also happens to be the framework on which accounting systems are built. After you spend a bit of time becoming reacquainted with the balance sheet, you ll be all set to learn about the system of accounting a topic that you ll be hearing lots about in this chapter and in Chapters 3 and 4. Although the accounting system tracks the results of all types of business activities, we focus on investing and financing in this chapter. (We ll spend Chapters 3 and 4 looking at how accounting systems track the results of operating activities, which affect both balance sheet and income statement accounts.) This chapter closes with a look at concepts that relate to the balance sheet. The goals that you should be trying to achieve when reading Chapter 2 are presented as Learning Objectives on the first page of this chapter. UNDERSTAND What a Balance Sheet Means to Users The unit of measure assumption states that results of business activities should be reported in an appropriate monetary unit. A classified balance sheet is one that classifies assets and liabilities into current and other (long-term) categories. BUSINESS ACTIVITIES AND COMMON BALANCE SHEET ACCOUNTS To understand the items reported on the balance sheet of an FCH store, it s useful to first think about what s involved in getting a hair salon up and running. First, you will need to decide on a location. Because the idea behind FCH is to make hair care convenient for customers, you ll try to find space for your salon in a neighbourhood shopping mall, anchored by either a major grocery chain or mass merchandiser. This will ensure your salon attracts what are known as destination shoppers. These are customers who avoid spending time driving from the grocery store to the video store to a hair salon. They want to do it all at one place, and your mall location makes this possible. Okay, now that you ve selected a location, you ll need to start investing in some assets. First, you ll need to renovate your salon space so that it presents an open and airy environment, consistent with the standard FCH design. Typically, these renovations take four to six weeks to complete and cost about $42,000. You ll also need to spend an additional $18,000 to buy furniture and equipment for the salon. This might seem like a lot of money, but, the next time you get your hair cut, just take a look around at all the different furnishings in a hair salon. You ll likely see a reception desk, lighting fixtures, styling chairs, shampoo stations, computer hardware (and software), mirrors, scissors, trimmers, razors, curlers, and dryers and those fuzzy pink rollers. But wait! You (and your parents) have got only $50,000 to contribute to starting up a company. To finance the cost of all those assets, you ll need to consider getting a loan from a bank. A $20,000 loan would give the company enough cash to pay for furniture and equipment and still leave some money to pay for operating supplies like shampoo and all that other hair gunk. From the above description and what you remember from Chapter 1, try to think of the accounts that are likely to appear on the balance sheet of your FCH store. Really, cover up Exhibit 2.1 and take 10 seconds to picture what should be on the balance sheet of your business. When you re done, compare it with the balance sheet in Exhibit 2.1. FCH salons operate in Canadian dollars. When a salon reports its results to Regis Corp., its parent company in the United States, it is important that the salon clearly states that the unit of measure used in its statements is millions of Canadian dollars so that Regis is not confused. All companies state the currency they use in their statements. For example, Sony reports in yen, Lego in Danish krone, and Adidas in euros. So, how did you do? The most important thing at this stage is that you knew to think about assets, liabilities, and shareholders equity accounts. To extend your thinking a bit, Exhibit 2.1 separately classifies some assets and liabilities as current. This is called a classified balance sheet. We haven t created new accounts to do this. We ve simply cut the assets and liabilities into current and long-term sections when reporting them in the

3 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 43 exhibit 2.1 Sample Balance Sheet and Explanation of Items FIRST CHOICE HAIRCUTTERS SALON Balance Sheet At August 31, 2009 (in Cdn. dollars) Who What When Unit of measure Assets Current Assets Cash $10,000 Cash in company s bank account Supplies 630 Shampoo and other hair products to be used on customers Total Current Assets 10,630 10, Furnishings and Equipment 60,000 Cost of store renovations, furniture, and equipment Total Assets $70,630 10,630 60,000 Liabilities Current Liabilities Accounts Payable $ 630 Amount owed to supplier for purchases of supplies on account Total Current Liabilities 630 Notes Payable 20,000 Amount owed to bank for loan (under a formal agreement) Total Liabilities 20, ,000 Shareholders Equity Contributed Capital 50,000 Amount contributed by shareholders (you and your parents) Retained Earnings 0 No operations yet, so no earnings to report as retained Total Shareholders Equity 50,000 50,000 0 Total Liabilities and Shareholders Equity $70,630 20,630 50,000 balance sheet, as suggested in Exhibit 2.2. Current Assets are the resources that your business owns because of a past transaction that will be used up or turned into cash within the next 12 months. Your business will spend the Cash and use the Supplies that are reported at August 31, 2009, during the next 12 months, so they are classified as current. On the other hand, the Furnishings and Equipment will last five to ten years, so they are reported outside of the current asset category to indicate that they are long-term assets. Notice that assets are listed in the order of how fast they will be used up or can be turned into cash. Note also that all assets share the key feature of having probable future economic benefits. In the liabilities section of the balance sheet, back in Exhibit 2.1, you again see the current subheading. Go ahead, take a look. Current Liabilities are debts and other obligations that are to be paid or settled within the next 12 months. In our example, Accounts Payable is the only current liability. This line on the balance sheet shows the amounts still owed for things that were bought on credit and will be paid off within the next 12 months. Liabilities not included as current are considered long-term liabilities. In our example, Notes Payable represents amounts that your FCH salon owes to the bank. More than likely, your company has signed an agreement (or note ) to repay these amounts several years from now. Notice that all liabilities (whether current or long-term) require a future sacrifice of resources because of a past transaction this is one of their key features. The first account in the shareholders equity section, Contributed Capital, includes the amount of financing contributed to the company by shareholders. The next account is Retained Earnings. In our FCH example, there is no amount reported for this account. Current assets will be used up or converted into cash within the next 12 months. Long-term assets include resources that will be used up or turned into cash more than 12 months after the balance sheet date. Current liabilities are debts and obligations that will be paid or settled within the next 12 months. Long-term liabilities are debts and obligations that will be paid or settled more than 12 months from the balance sheet date.

4 44 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet COACH'S TIP Assets are said to have probable future benefits because they re likely to be used up or turned into cash (but there s rarely a 100 per cent guarantee of this). exhibit 2.2 Cutting Assets and Liabilities into Current and Long-Term Assets Liabilities Current Current Long-term Long-term Shareholders Equity A classified balance sheet cuts assets and liabilities into current and long-term sections. Total assets (current and long-term) are equal to total liabilities (current and long-term) plus shareholders equity. The chart of accounts is a summary of all account names and corresponding account numbers used to record financial results in the accounting system. This makes sense because your business isn t open to customers yet, so there can t be any earnings to report as having been retained by the company. Don t be surprised if you used account names that differ from what we used in Exhibit 2.1. It s okay to use different account names as long as they have the same meaning as ours and are properly classified as assets, liabilities, or shareholders equity. In the real world of financial reporting, even commonly used accounts are given different labels by different companies. Depending on the company, you may see a liability for a bank loan called a note payable, loan payable, or simply long-term debt. When choosing names, most companies will attempt to use names that already exist, if appropriate, or come up with one that describes the underlying business activity. Once an account name is selected, it is given a reference number (for the accounting system to recognize), and this exact name and number are used for all business activities affecting that account. A summary of account names and numbers, called the chart of accounts, is kept by each company and is used to ensure consistency in reporting its own financial results. Some common balance sheet accounts (without the numbers) from a typical chart of accounts are listed in Exhibit 2.3. The accounts in boldface appear in FCH s balance sheet in Exhibit 2.1, except that, for FCH, Property, Plant, and Equipment is Furnishings and Equipment. You ll come across the other accounts in later chapters. STUDY How to Analyze Transactions Transaction analysis is the process of studying a transaction to determine its economic effect on the business in terms of the accounting equation. TRANSACTION ANALYSIS You may not have realized it, but in the previous section of this chapter you were already beginning to learn one of the key steps of accounting: analyzing business activities and determining their financial statement effects. Your instructor is likely to refer to this step as transaction analysis. Although a single phrase is used to describe this step, it actually has two parts: (1) analyzing business activities and (2) identifying transactions. The first part describes what you look at (business activities), and the second part describes what you look for (transactions). In other words, transaction analysis involves thinking about each business activity of your company with the goal of finding transactions that should

5 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 45 exhibit 2.3 Excerpt from Chart of Accounts (Balance Sheet Accounts Only) Account Name Cash Accounts Receivable Interest Receivable Inventories Supplies Prepaid Expenses Notes Receivable ASSETS Description Includes cash in the bank and in the cash register Amounts owed to your business by customers for sales made on credit Interest owed to your business by others Goods on hand that are being held for resale Items on hand that will be used to make goods or provide services Rent, insurance, and other expenses paid for future services Amounts lent to others under a formal agreement ( note ) COACH'S TIP Read this chart of accounts but don t memorize it. Also, don t try to force this chart of accounts on all problems. When using account names in homework problems, follow a process similar to what companies do. Consider whether a common name already exists or is given in the problem. If there isn t one, make up a descriptive one. After you have chosen an account name, be sure to use it consistently throughout the problem. Property, Plant, and Equipment Cost of land, buildings, and equipment Intangible Assets Other Assets Trademarks, brand names, other rights that lack a physical presence A variety of assets with smaller balances LIABILITIES Accounts Payable Wages Payable Accrued Liabilities Unearned Revenues Notes Payable Bonds Payable Other Liabilities Amounts owed to suppliers for goods or services bought on credit Amounts owed to employees for salaries, wages, and bonuses Amounts owed to others for advertising, utilities, interest, etc. Amounts (customer deposits) received in advance of providing goods or services to customers Amounts borrowed from lenders; involves signing a promissory note Amounts borrowed from lenders; involves issuance of bonds A variety of liabilities with smaller balances SHAREHOLDERS EQUITY Contributed Capital Retained Earnings Amount of cash received for shares issued Amount of accumulated earnings not distributed as dividends be recorded in the accounting information system. To do this well, you first need to know what a transaction is. An accounting transaction is an exchange or event that has a direct economic effect on the assets, liabilities, or shareholders equity of a business. Most transactions are observable external events exchanges involving assets, liabilities, and shareholders equity that you can see between the company and someone else. When Starbucks sells you one of its exclusive Frappucino coffee-blended beverages, it is exchanging an icy taste of heaven for your cash. This is an external transaction that needs to be recorded in Starbucks accounting system. These are the easiest transactions to understand, and we concentrate on these in Chapters 2 and 3. Some transactions are trickier to identify because you can t really see them occur. An example of this type of transaction involves the interest cost that racks up on a bank loan as time passes. You don t see anything happen (other than the calendar page flipping A transaction is an exchange or event that has a direct economic effect on the assets, liabilities, or shareholders equity of a business.

6 46 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet over), but an event has occurred that has a direct economic effect on the business: It now has an obligation (liability) to pay the interest that the bank charges. We look at these in Chapter 4. Although many business activities have direct economic effects on a company, some have only indirect effects, which are not recorded. For example, signing an agreement is not considered a transaction because it typically involves the exchange of only promises, not assets, liabilities, or shareholders equity. If you were to sign an employment contract to hire a new stylist at your FCH store, no transaction occurs from an accounting point of view because no exchange of assets, liabilities, or shareholders equity occurred when the contract was signed. The company merely agreed to pay the stylist, and she merely agreed to snip away at your customers heads. This was only an exchange of promises. Sure, when she actually pulls out her scissors and leaves a mound of your professor s hair on the floor, your business will then be obligated to pay her for the services she has provided to your business, resulting in a transaction. However, until that time, there is only a promise of an exchange to occur at some time in the future. Of course, if you were actually to pay a cash bonus for her to sign the contract, like the $2.5 million Reebok reportedly paid to hockey phenom Sidney Crosby when he was 17 years old, then it would involve an exchange that is considered a transaction. 1 THE IDEAS BEHIND TRANSACTION ANALYSIS Two simple ideas are used when analyzing transactions: 1. Duality of effects. It s a fancy name, but the idea is simple. Every transaction has at least two effects on the basic accounting equation. To remember this, just think of expressions like give and take or push and pull or, if you re a closet scientist, Newton s Third Law of Motion. Just as every story has at least two sides and you never get something for nothing, every transaction affects at least two accounts. 2. A L SE. You know this already, right? You studied the basic accounting equation on page 5 in Chapter 1. Remember that assets always must equal liabilities plus shareholders equity for every accounting transaction. If it doesn t, then you are missing something and you should go back to the first (duality of effects) idea. Let s do a few examples to show how these ideas are used when analyzing transactions. Suppose that your FCH store paid cash to buy Tigi s Hard Head Hair Spray (supplies). This is a transaction because an exchange exists between your business and Tigi. Applying the duality of effects idea, look for the give and take in this transaction, where we have replaced takes with the more polite receives : COACH'S TIP Computerized accounting packages do not eliminate the need for learning transaction analysis and reporting. To use these packages effectively, you need to understand the basics described in the following sections. Duality of Effects FCH FCH Transaction Gives Receives Purchased hair spray supplies for cash Cash Supplies Now, let s check to see whether the basic accounting equation still holds: Accounting Equation A L SE Cash Supplies No change No change As you can see, the decrease in one asset (cash) is offset by the increase in another asset (supplies), and there are no changes in liabilities or shareholders equity. Consequently, the accounting equation remains in balance, as it should. 1 Big Market Means Big Dough for Crosby, Edmonton Journal, July 21, 2005.

7 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 47 In the above example, your FCH store paid cash to Tigi immediately upon receiving the supplies. When most companies buy goods or services from another company, they do so on credit with the promise to pay for it later. For the next example, let s assume that your store receives a case of Shine Junkie from Tigi and pays for this purchase at the end of the month. In this example, your FCH store has entered into two transactions: (1) the purchase of an asset on credit and (2) the eventual payment. In the first, your business receives supplies (an increase in an asset) and in return gives a promise to pay later, called accounts payable (an increase in a liability). Duality of Effects FCH FCH Transaction Gives Receives (1) Purchased hair supplies on credit Accounts payable Supplies (promise to pay) Notice that A L SE for this transaction, as shown below. COACH'S TIP Any account name with the word payable is a liability. Accounting Equation A L SE (1) Supplies Accounts Payable No change In the second transaction, your store gives up cash (a decrease in an asset) to fulfill its promise to pay Tigi and, as a result, takes back its promise (a decrease in the liability called accounts payable). Think of this as taking back (receiving) an IOU you had previously given to someone. Once it is back in your hands, you no longer owe the money. Check the following table to see whether this analysis fits the duality of effects requirement described above. Duality of Effects FCH FCH Transaction Gives Receives (2) Paid the amount owed Cash Accounts payable on account payable (the promise has been fulfilled) Now, let s make sure that the basic accounting equation is still in balance after we enter these effects: Accounting Equation A L SE (2) Cash Accounts Payable No change Note that the accounting equation remained in balance after each of the two transactions. In the first, the increase in an asset was accompanied by a corresponding increase in a liability, and, in the second, the decrease in an asset was accompanied by a corresponding decrease in a liability. Although you haven t seen it yet in this chapter, you also will run into transactions where a shareholders equity account changes and is accompanied by a corresponding change in either an asset or liability account. We should warn you that, when first learning transaction analysis, you might be tempted to rush to identifying what accounts are affected while accidentally skipping over the important task of determining whether a transaction even exists. Remember, for a transaction to exist, there must be some kind of exchange or event that has a direct economic effect on your company. If your store sent an order to Tigi for more slick-styling

8 48 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet products and Tigi promised to send them next week, no transaction has taken place from an accounting point of view. Two promises have been exchanged; that s all. As soon as the goods are shipped to your FCH store, however, your business has exchanged a promise to pay for goods that you actually received, so a transaction has taken place, and the financial statements of your FCH store will be affected. COACH'S TIP Don t skip this section! Most students say that, of all the topics in this course, transaction analysis is the one they wished they had spent more time on when first learning it. DECIDE: A SYSTEMATIC APPROACH TO TRANSACTION ANALYSIS Use these steps when analyzing transactions, to DECIDE on the accounting effects: 1. D oes a transaction exist? Go to step 2 only if your answer is yes. 2. E xamine it for the accounts affected. Put names on what is given and what is received. 3. C lassify each account as asset (A), liability (L), or shareholders equity (SE). 4. ID entify the direction and amount of the effects. By how much does each asset, liability, and shareholders equity account increase or decrease? 5. E nsure that the basic accounting equation still balances. Because the best way to learn how to account for business activities is to work through examples, let s analyze some typical financing and investing transactions, using this DECIDE approach. Assume the following events took place in August. ( a ) You incorporate First Choice Haircutters Salon on August 1. The company issues shares to you and your parents in exchange for $50,000, which is deposited in the company s bank account. 1. Does a transaction exist? Yes, because cash is received and shares are given 2. Examine it for accounts affected. Cash and Contributed Capital. 3. Classify each account affected. Cash is an asset (A), and Contributed Capital is shareholders equity (SE). 4. IDentify direction and amount. Cash (A) $50,000 and Contributed Capital (SE) $50, Ensure the equation still balances. Yes, because Assets $50,000 Shareholders Equity $50,000 (see below) Assets Liabilities Shareholders Equity Ref. Cash Contributed Capital (a) 50,000 50,000 Notice that, in the table above, we included a transaction reference ( a ) so that we can refer back to the original transaction description if needed. You, too, should use transaction letters (or numbers or dates) as references in your homework problems. When first learning how to account for transactions, some people forget that they should examine them from the point of view of the company, not the company s owners. As you saw in Chapter 1, the separate entity concept states that personal transactions of the owners of a business are not to be mixed in with the results of the business itself. So if you thought transaction ( a ) involved an increase in an asset called stock investment (or something like that), you probably forgot to analyze the transaction from the company s point of view. For First Choice Haircutters Salon, the issuance of shares is a financing activity (not an investment), which was recorded as contributed capital in shareholders equity.

9 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 49 ( b ) A construction company renovates your store space at a cost of $42,000, which your company pays in cash. 1. Does a transaction exist? Yes, because renovations have been received and cash is given 2. Examine it for accounts affected. Furnishings and Equipment and Cash 3. Classify each account affected. Furnishings and Equipment is an asset (A), and Cash is an asset (A). 4. IDentify direction and amount. Furnishings and Equipment (A) 42,000 and Cash (A) $42, Ensure the equation still balances. Yes, because Assets $42,000 $42,000 no change (see below) Shareholders Assets Liabilities Equity Furnishings and Contributed Ref. Cash Equipment Capital (a) 50,000 50,000 (b) 42,000 42,000 No change ( c ) Your company installs $10,000 worth of equipment in the salon, paying $8,000 in cash and promising to pay the remaining $2,000 at the end of the month. 1. Does a transaction exist? Yes, because equipment has been received, and cash and a promise to pay have been given 2. Examine it for accounts affected. Furnishings and Equipment, Cash, and Accounts Payable 3. Classify each account affected. Furnishings and Equipment is an asset (A), Cash is an asset (A), and Accounts Payable is a liability (L). 4. IDentify direction and amount. Furnishings and Equipment (A) 10,000, Cash (A) $8,000, and Accounts Payable (L) $2, Ensure the equation still balances. Yes, because Assets $2,000 Liabilities $2,000 (see below) Shareholders Assets Liabilities Equity Furnishings and Accounts Contributed Ref. Cash Equipment Payable Capital (a) 50,000 50,000 (b) 42,000 42,000 (c) 8,000 10,000 2,000 If you ever run into a transaction that you have no idea how to analyze, simply break it down. Rather than trying to solve it all at once, begin by looking just for what is received. This E xamine step is crucial, and you may find that the reason you were having trouble is that there was more than one item received. After you find what is received, look just for what is given. Again, you may find that, as in event (c) here, more than one item is involved. After you C lassify and ID entify, E nsure the accounting equation remains in balance, because this may give you a clue about whether you ve detected all the accounts affected.

10 50 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet ( d ) Your company borrows $20,000 from a bank, depositing those funds in its bank account and signing a formal agreement to repay the loan in two years. 1. Does a transaction exist? Yes, because cash has been received and a formal promise to pay ( note ) has been given 2. Examine it for accounts affected. Cash and Notes Payable 3. Classify each account affected. Cash is an asset (A) and Notes Payable is a liability (L). 4. IDentify direction and amount. Cash (A) 20,000 and Notes Payable (L) $20, Ensure the equation still balances. Yes, because Assets $20,000 Liabilities $20,000 (see below) Shareholders Assets Liabilities Equity Furnishings and Accounts Notes Contributed Ref. Cash Equipment Payable Payable Capital (a) 50,000 cr 50,000 (b) 42,000 42,000 (c) 8,000 10,000 2,000 (d) 20,000 20,000 ( e ) Your company orders $800 worth of shampoo and other operating supplies from Tigi. None have been received yet. 1. Does a transaction exist? No, because nothing has been received and only a promise has been given Okay, it s time for you to start taking over. As you read transactions ( f ) to ( h ) below, use the five-step DECIDE approach and fill in the highlighted blanks in the self-study quiz. See(h) on the next page where you can summarize the effects of each transaction on the accounting equation at the end of the self-study quiz. HOW S IT GOING? A Self-Study Quiz (f) Your company buys $8,000 worth of furniture, paying the full amount in cash. 1. Does a transaction exist? Yes, because cash is given and furniture is received 2. Examine it for accounts affected. Cash and Furnishings and Equipment 3. Classify each account affected. Cash is an asset (A) and Furnishings and Equipment is ( ) 4. IDentify direction and amount. Cash (A) $8,000 and Furnishings and Equipment ( ) $ 5. Ensure the equation still balances. Yes, because Assets $8,000 $8,000 No change

11 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 51 (g) Your company pays the $2,000 owed to the equipment supplier in (c). 1. Does a transaction exist? Yes, because 2. Examine it for accounts affected. Cash and Accounts Payable 3. Classify each account affected. Cash is an asset (A) and Accounts Payable is a liability (L). 4. IDentify direction and amount. Cash (A) $2,000 and Accounts Payable (L) $2, Ensure the equation still balances. Yes, because. Note that (g) doesn t increase the Furnishings and Equipment asset again because the equipment was recorded in (c) at its full cost ($10,000) rather than at the amount of cash given when the equipment was received. This is an important concept (called the cost principle) that we will return to at the end of the chapter. (h) Your company receives $630 worth of the supplies ordered in (e) and promises to pay for them next month. 1. Does a transaction exist? Yes, because supplies are received and a promise to pay is given 2. Examine it for accounts affected. Supplies and Accounts Payable 3. Classify each account affected. Supplies is an asset (A) and Accounts Payable is a liability (L). 4. IDentify direction and amount. Supplies (A) $ and Accounts Payable (L) $ 5. Ensure the equation still balances. Yes, because assets and liabilities increase by the same amount Shareholders Assets Liabilities Equity Furnishings and Accounts Notes Contributed Ref. Cash Supplies Equipment Payable Payable Capital (a) 50,000 50,000 (b) 42,000 42,000 (c) 8,000 10,000 2,000 (d) 20,000 20,000 (f) 8,000 (g) (h) Total 10, , ,000 50,000 After you have finished, check your answers with the solutions presented in the margin. If your answers did not agree with ours, you should go back to each event to ensure that you completed each of the steps of transaction analysis. Quiz Answers (f) Furnishings and Equipment is an asset (A), which increases ( $8,000). (g) A transaction exists because your company fulfills (takes back) its promise to pay the equipment supplier by giving cash. The accounting equation balances because assets (on the left-hand side) and liabilities (on the right-hand side) decrease by the same amount ( $2,000). (h) Supplies (A) $630 and Accounts Payable (L) $630

12 52 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet COACH'S TIP The self-study quiz that you just finished involved a company s first month of operations. As a result, the net changes during the month lead directly to the ending balances, which would be reported on a balance sheet. Notice that the totals in the self-study quiz correspond to the amounts shown in Exhibit 2.1 on page 43. A journal is organized by date, and shows each day s transactions. A ledger is organized by account, and shows the effects of the day s transactions on the accounts. Accounts are those items a company wants to keep track of, such as its cash, its accounts payable, and its wages expense. The balances in the accounts provide the numbers that appear in the financial statements. EVALUATE Transactions Using the Debit/Credit Framework It s possible to use a spreadsheet for entering the effects of transactions directly into the various accounts. By adding the increases, subtracting the decreases, and including the balances at the beginning of the month for each account, we could compute the ending balance in each account to be reported then on the balance sheet. Although this method would work, you can just imagine how impractical it would be in a company like Regis Corporation, which has transactions with about 12 million customers and 51,000 employees every month. Rather than create a spreadsheet as big as three football fields, a more sophisticated system is used to record and summarize transactions. Fortunately, your experience as a student has made you familiar with a system of learning similar to the system used in accounting. Day after day, you go to class, take notes, go to class, take notes, repeat. The reason you take notes is to create a record of what happened in each class, kind of like an academic diary or journal. Then, when preparing for exams, you probably copy these notes to summary sheets to study from. These summary sheets make it easier to understand all those things you noted earlier in the month. The system of accounting also uses this combination of note-taking and summarizing. First, a daily record of events (transactions) is noted in a journal. These journal entries are copied ( posted ) to summary sheets that show, for each balance sheet account, the effects of the month s transactions. These summary sheets (which, as a group, are called a ledger) then become the basis for preparing financial statements. Exhibit 2.4 illustrates this process. Notice how the transaction on August 1 to issue shares, which increased the company s cash and contributed capital (as noted in the journal), can be seen in the Cash account in the ledger. The final step in the process, using the ledger to prepare the financial statements, is studied in Chapter 4. Typically, when people are first shown an accounting journal and ledger, they have a tough time telling them apart. Take a quick look at Exhibit 2.4 again. Does it seem as though the journal and ledger pages look a lot alike? Both include dates, amounts, and lots of columns, so do they really differ from one another? Actually, yes. We will highlight their differences in the following sections by using simplified formats that strip away many of the lines (and some of the columns) that can make a journal and ledger exhibit 2.4 The Accounting Process SYSTEM OF ACCOUNTING Transactions Journal Ledger Date Account Titles Aug. 1 Cash Contributed Capital Debit 50,000 Credit 50,000 Date Cash Increases Decreases Balance Aug. 1 50,000 Aug. 10 Aug. 11 Aug ,000 Aug. 30 Aug ,000 42,000 8,000 8, ,000 8,000 12,000 2,000 10,000 Financial Statements CASH FLOW RETAINED EARNINGS INCOME STATEMENT

13 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 53 look alike. These simplified formats should make it easier for you to distinguish the two types of accounting records and to focus on the main benefits of a journal (to take note of daily transactions) and a ledger (to summarize for each account the effects of those transactions). We ll start with the simplified version of a ledger account, which is called a T-account. One more glance at the ledger page in Exhibit 2.4 should reveal how a T-account gets its name. (Can you see the T in the ledger account for Cash? T-ACCOUNTS: SEPARATING INCREASES AND DECREASES IN THE BASIC ACCOUNTING EQUATION Each item on the balance sheet has its own T-account, which separately summarizes the increases and decreases that occur during the accounting period. Because assets appear on the left-hand side of the basic accounting equation (A L SE), each asset T-account includes increases on the left side of the T (decreases go on the right side of the T). For liabilities and shareholders equity, which appear on the right-hand side of the accounting equation, increases are included on the right side of the T (and decreases go on the left). Increases Assets Decreases Decreases Liabilities Increases Shareholders Equity Decreases Increases Take a moment to see how the increase symbol appears on the left side of the T for accounts on the left side of the accounting equation, and on the right side of the T for accounts on the right side of the equation. This same balancing logic applies to decreases, which are on the side of the T closest to the equals sign. Now, just as boating enthusiasts use special terms like port and starboard to refer to different sides of a boat, accountants also use special terms to refer to different sides of an account. 2 The term debit refers to the left side and credit refers to the right, as Exhibit 2.5 shows. These terms (and their abbreviations dr and cr ) are based on Latin The T-account is a simplified version of an accounting ledger used in textbooks and classrooms for illustration purposes. COACH'S TIP Think of the accounting equation as a scale that tips at the equals sign. To keep the scale in balance, you need to put increases (and decreases) in assets on the opposite side used for increases (and decreases) in liabilities and shareholders equity. COACH'S TIP Here s another way to picture how debits and credits affect accounts: dr cr Assets Liabilities Shareholders Equity exhibit 2.5 The Difference between Debits and Credits DEBIT dr. CREDIT cr. 2 Thanks to Rita Cook for sharing this analogy.

14 54 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet exhibit 2.6 Transaction Analysis Model Assets Liabilities Shareholders Equity Increases dr Decreases cr Decreases dr Increases cr Decreases dr Increases cr COACH'S TIP Think of the accounting equation A L SE. Assets in this equation appear on the left-hand side or the debit side so an asset s normal balance is a debit. Liabilities and equity appear on the right-hand side or credit side of the equation so these accounts will normally have a credit balance. Journal entries note the effects of each day s transactions on financial statement accounts. words that had real meaning back in those days, but today they just mean left and right. The journal columns in Exhibit 2.4 use the terms debit and credit. To make this as easy for you as possible, we ve combined these ideas in Exhibit 2.6, which we call the transaction analysis model. As you work on more transaction analysis exercises later in this chapter, you should refer to this model as often as you need to, until you can create it on your own without help. You should note the following from the transaction analysis model in Exhibit 2.6 : Asset accounts increase on the left (debit) side. Because they increase on the left, they almost always have debit balances at the end of a month. It would be highly unusual for an asset account, such as inventory, to have a negative (credit) balance. Liabilities and shareholders equity accounts increase on the right (credit) side, and normally have credit balances. It s highly unusual for a liability or shareholders equity account, such as contributed capital, to have a negative (debit) balance. In every transaction, the total dollar value of all debits equals the total dollar value of all credits. Later, we will add this equality check (Debits Credits) to our DECIDE transaction analysis approach. After all transactions are posted, asset accounts normally have debit balances and liabilities and shareholders equity accounts normally have credit balances. Okay, now that you ve seen how the T-account works as a simplified version of a ledger account, let s move on to the simplified format for noting each day s transactions in a journal. JOURNAL ENTRIES A debit-and-credit format is used when transactions are initially entered into the journal. Once transactions have been identified and analyzed, journalizing is the first step in the recording process. The formal format for these journal entries, as they are called, was shown in Exhibit 2.4. For purposes of this course, we will use the following simplified format: (a) dr Cash ( A) ,000 cr Contributed Capital ( SE) ,000 Notice the following about the simplified journal entry format shown above: The source of the transaction is referenced using a number or letter, like the ( a ) given in our original description of the transaction. For each transaction, debits are written first (at the top) and credits are written below the debits. The account names and amounts to be credited are indented to the right. We recommend you also distinguish debits from credits by using dr and cr before the name of each account that is to be debited or credited. Total debits equal total credits ($50,000 $50,000).

15 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 55 While you are learning to perform transaction analysis, use the symbol A, L, or SE after each account name, as we did. By identifying accounts as assets (A), liabilities (L), or shareholders equity (SE), you will become more familiar with the various types of accounts and you ll make it easier for others to interpret your journal entries. In the next few chapters, we include the direction of the effect before the symbol. For example, if the asset account Cash is to be increased (debited), we will show it as dr Cash ( A). TRANSACTION ANALYSIS REVISITED Now that you ve been introduced to debits, credits, journal entries, and T-accounts, you are ready to revisit the five-step DECIDE approach used earlier to analyze transactions. To include these new concepts in the accounting process, we need to add two more steps, as highlighted in Exhibit 2.7. exhibit 2.7 Transaction Analysis: The DECIDES Approach 1. Does a transaction exist? 2. Examine it for accounts affected. 3. Classify each account affected. 4. Identify direction and amount. 5. Debit and credit the accounts affected. 6. Ensure the equation still balances and debits credits. 7. Summarize the transaction effects in T-accounts. In the remainder of this section, we will work with you to use this transaction analysis approach to record the monthly transactions that were presented earlier in this chapter for your First Choice Haircutters Salon. Because we have completed steps 1 to 4 of the transaction analysis for these events already, we will not show them below, but you should understand that these steps would be performed had we not analyzed them earlier. The analysis below focuses on the results of steps 5 to 7, which involve the new concepts of debits, credits, journal entries, and T-accounts. COACH'S TIP Study all the material in this section carefully. This material is critical for understanding nearly all the remaining topics in this book. Spending time on this now will save you hours and hours of work and confusion later in the course. ( a ) You incorporate First Choice Haircutters Salon on August 1. The company issues shares to you and your parents in exchange for $50,000, which is deposited in the company s bank account. Debit and credit the accounts affected. dr Cash ( A) ,000 cr Contributed Capital ( SE) ,000 Ensure the equation still balances and debits credits. Assets Liabilities Shareholders Equity Cash 50,000 Contributed Capital 50,000 Equality checks: (1) The accounting equation is in balance; (2) Debits $50,000 Credits $50,000. Summarize the transaction effects in T-accounts. Beg. bal. 0 (a) 50,000 dr Cash (A) cr dr Contributed Capital (SE) cr 0 Beg. bal. 50,000 (a) Beg. bal. stands for beginning balance: the balance in the account before the transaction is posted.

16 56 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet Your homework exercises will likely ask you to create a list of journal entries for all transactions before posting any of them to T-accounts. We show the journal entries and T-account postings together here, to show you how the posting to T-accounts simply involves copying the debit or credit amount from each line of the journal entry to the debit or credit side of the corresponding T-accounts. (b ) A construction company renovates your store space at a cost of $42,000, which your company pays in cash. Debit and credit the accounts affected. dr Furnishings and Equipment ( A) ,000 cr Cash ( A) ,000 Ensure the equation still balances and debits credits. Assets Liabilities Shareholders Equity Furnishings and Equipment 42,000 Cash 42,000 Equality checks: (1) the accounting equation is in balance; (2) Debits $42,000 Credits $42,000. Summarize the transaction effects in T-accounts. dr Cash (A) cr Beg. bal. 0 (a) 50,000 42,000 (b) dr Furnishings & Equipment (A) cr Beg. bal. 0 (b) 42,000 Journalize is the process of recording a transaction in the journal in the debitsequal-credits journal entry format. Notice above that the Cash T-account includes the postings for transactions ( a ) and ( b ). This accumulation of cash effects will continue until all of the month s transactions involving cash are included, at which time we will compute a total balance in the account by adding all the amounts in the debit column (increases) and subtracting all the amounts in the credit column (decreases). The excess of debits over credits will become the ending balance in this asset account, and it will carry over to become the beginning balance in the following month. But we ve got a bunch more transactions in the month to journalize and post before we start totalling the T-accounts. ( c ) Your company installs $10,000 worth of equipment in the salon, paying $8,000 in cash and promising to pay the remaining $2,000 at the end of the month. Debit and credit the accounts affected. dr Furnishings and Equipment ( A) ,000 cr Cash ( A) ,000 cr Accounts Payable ( L) ,000 Ensure the equation still balances and debits credits. Assets Liabilities Shareholders Equity Furnishings and Equipment 10,000 Accounts Payable 2,000 Cash 8,000 Equality checks: (1) The accounting equation is in balance; (2) Debits $10,000 Credits $10,000. Summarize the transaction effects in T-accounts. dr Cash (A) cr Beg. bal. 0 (a) 50,000 42,000 (b) 8,000 (c) dr Furnishings and Equipment (A) cr Beg. bal. 0 (b) 42,000 (c) 10,000 cr Accounts Payable (L) dr 0 Beg. bal. 2,000 (c)

17 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 57 Let s briefly go over transaction ( c ), which affects three accounts: Furnishings and Equipment, Cash, and Accounts Payable. Because equipment was received, we need to record an increase in the asset account Furnishings and Equipment. The debit/credit rules indicate that asset increases are recorded on the left (debit) side of the T-account, so the journal entry includes a debit to Furnishings and Equipment for the $10,000 equipment cost. Because cash was given up, we need to record a decrease in the asset account Cash. The debit/credit rules indicate that asset decreases are recorded on the right (credit) side, so the journal entry includes a credit to Cash for the $8,000 given up. Because the company also gave a promise to pay the remaining $2,000, we need to record an increase in the liability Accounts Payable. The debit/credit rules indicate that liability increases are recorded on the right (credit) side of the T-account, so the journal entry includes a credit to Accounts Payable for $2,000. The net increase in assets of $2,000 ($10,000 $8,000) is equal to the increase in liabilities of $2,000 (so the accounting equation is in balance), and the debit of $10,000 equals total credits of $10,000 ($8,000 $2,000). ( d ) Your company borrows $20,000 from a bank, depositing those funds in its bank account and signing a formal agreement to repay the loan in two years. Debit and credit the accounts affected. dr Cash ( A) ,000 cr Notes Payable ( L) ,000 Ensure the equation still balances and debits credits. Assets Liabilities Shareholders Equity Cash 20,000 Notes Payable 20,000 Equality checks: (1) The accounting equation is in balance; (2) Debits $20,000 Credits $20,000. Summarize the transaction effects in T-accounts. dr Cash (A) cr Beg. bal. 0 (a) 50,000 42,000 (b) (d) 20,000 8,000 (c) dr Notes Payable (L) cr 0 Beg. bal. 20,000 (d) Let s move on to event ( e ), which involved ordering (but not yet receiving) supplies from Tigi. Because this involved the exchange of only promises, it was not considered a transaction. For this reason, no journal entry is needed for event ( e ). Are you getting the hang of it? The best way to know for sure is to try accounting for some transactions on your own. In the following self-study quiz, we will provide you with space to complete journal entries for three transactions. Complete each of the three journal entries first (as if you are recording transactions for a real company on a daily basis), and then summarize the effects in the corresponding T-accounts (as if you are posting the journal entries at the end of the month). The T-accounts are in Exhibit 2.8 on page 58.

18 58 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet HOW S IT GOING? A Self-Study Quiz For events (f), (g), and (h) below, complete the journal entries and then post their effects to the T-accounts in Exhibit 2.8. Then check your answers with the solution at the end of the illustration. (f) Your company buys $8,000 worth of furniture, paying the full amount in cash. Debit and credit the accounts affected. COACH'S TIP Try to fill in the missing line(s) of the journal entry, using only the description of the transaction. If you need some help, peek at the effects on the accounting equation. Don t forget to post the journal entry effects to the T-accounts in Exhibit 2.8. dr ( ) cr Cash ( A) ,000 Ensure the equation still balances and debits credits. Assets Liabilities Shareholders Equity Furnishings and Equipment 8,000 Cash 8,000 Equality checks: (1) the accounting equation is in balance; (2) Debits $8,000 Credits $8,000. Summarize the transaction effects in T-accounts. T-accounts are presented together in Exhibit 2.8. (g) Your company pays the $2,000 owed to the equipment supplier in (c). (h) Journal Entry dr Supplies ( A) 630 cr Accounts Payable ( L) 630 Debits $630 Credits $630 Quiz Answers (f) Journal Entry dr Furnishings and Equipment ( A) 8,000 cr Cash ( A) 8,000 (All) Posting to T-Accounts Verify that you properly posted the journal entries to the T-accounts by adding the increase side and subtracting the decrease side. The amount you get for each account should be the same as the doubleunderlined amount shown as the ending balance. (g) Journal Entry dr Accounts Payable ( L) 2,000 cr Cash ( A) 2,000 Yes, the accounting equation is in balance. Debit and credit the accounts affected. dr Accounts Payable ( L) ,000 cr ( ) Ensure the equation still balances and debits credits. Assets Liabilities Shareholders Equity Cash 2,000 Accounts Payable 2,000 Equality checks: (1) Does the accounting equation balance? (2) Debits $2,000 Credits $2,000. Summarize the transaction effects in T-accounts. T-accounts are presented together in Exhibit 2.8. (h) Your company receives $630 worth of the supplies ordered in (e) and promises to pay for them next month. Debit and credit the accounts affected. dr ( ) cr ( ) Ensure the equation still balances and debits credits. Assets Liabilities Shareholders Equity Supplies 630 Accounts Payable 630 Equality checks: (1) the accounting equation is in balance; (2) Debits $ Credits $. Summarize the transaction effects in T-accounts. T-accounts are presented together in Exhibit 2.8.

19 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet 59 exhibit 2.8 T-Accounts Summarizing Transactions (a) to (h) A = L + SE Beg. bal. 0 (h) End. bal. 630 dr Cash (A) cr Beg. bal. 0 (a) 50,000 42,000 (b) (d) 20,000 8,000 (c) (f) (g) End. bal. 10,000 dr Supplies (A) cr dr Accounts Payable (L) cr 0 Beg. bal. (g) 2,000 (c) (h) dr Notes Payable (L) cr 630 End. bal. 0 Beg. bal. 20,000 (d) 20,000 End. bal. dr Contributed Capital (SE) cr 0 Beg. bal. 50,000 (a) 50,000 End. bal. dr Furnishings and Equipment (A) cr Beg. bal. 0 (b) 42,000 (c) 10,000 (f) End. bal. 60,000 Note: If you haven t already done so, post journal entries (f) to (h) to the T-accounts. This will involve filling in the white boxes in this exhibit. To compute the balance in T-accounts, draw a single line through each T-account below the amounts that you wish to total. Then calculate the ending balance by adding the increases to the beginning balance and deducting the decreases. For example, the equation for the ending balance in the Cash account is ($0 50,000 20,000 42,000 8,000 8,000 2,000 $10,000). Notice in Exhibit 2.8 that the ending balances are shown on the debit side with a double underline. UNADJUSTED TRIAL BALANCE After posting journal entries to the various accounts, it s usually a good idea to check that the total recorded debits equal the total recorded credits. Unlike computerized accounting systems that prevent you from letting the accounting records get out of balance, it s easy to make mistakes when you re doing it by hand. Typical mistakes involve (a) posting a debit as a credit, (b) posting only part of a journal entry, (c) recording the wrong amount, or (d) miscalculating the ending balance. The best way to ensure your accounts are in balance is to prepare a trial balance. The trial balance isn t part of the financial statements. It s actually an internal report used to determine whether total debits equal total credits. Exhibit 2.9 shows a trial balance, which lists all of the account names in one column (usually in financial statement order) and their ending balances (from Exhibit 2.8 ) in the appropriate debit or credit column. Occasionally, you may find that your trial balance is out of balance. This only happens when you ve made a mistake. Don t give up and hit Ctrl-Alt-Delete, because there are some shortcuts for finding the error. They all involve looking at the amount of the difference between total debits and total credits. A trial balance is a list of all accounts and their balances, which is used to check on the equality of recorded debits and credits.

20 60 chapter 2 Reporting and Interpreting Investing and Financing Results on the Balance Sheet exhibit 2.9 Sample Unadjusted Trial Balance FIRST CHOICE HAIRCUTTERS SALON Unadjusted Trial Balance As of September 30 Account Name Debits Credits Cash $ 10,000 Supplies 630 Furnishings and Equipment 60,000 Accounts Payable 630 Notes Payable 20,000 Contributed Capital 50,000 Totals $70,630 $70,630 COACH'S TIP Even if total debits equal total credits, it s still possible that you ve made an error. For example, if you accidentally debit an asset rather than an expense, total debits would still equal total credits. So, if they don t balance, you know you ve made an error. If they do balance, it s still possible that a mistake has been made (and you just don t know it). 1. If the difference is the same as one of your account balances, you probably forgot to include the account in the trial balance. 2. If the difference is twice the amount of an account balance, you may have reported the account on the wrong side of the trial balance. 3. If the difference is two times the amount of a particular transaction, you may have posted a debit as a credit or a credit as a debit in your T-accounts. 4. If the difference is evenly divisible by 9, you may have reversed the order of two digits in a number or left a zero off the end of a number. 5. If the difference is evenly divisible by 3, you may have hit the key above or below the one you intended to hit (like a 9 instead of a 6) on your calculator or numeric keypad. If you haven t already scanned the trial balance in Exhibit 2.9, take a moment to do it now. Notice that the title says unadjusted trial balance. It is called this because several adjustments will have to be made at the end of the accounting period to update the accounts. Don t worry about how to make the end-of-period adjustments yet. We ll spend all of Chapter 4 on that. For now, just realize that the accounts still have to be adjusted before we can prepare financial statements that follow generally accepted accounting principles. PREPARING A BALANCE SHEET It s easy to prepare a balance sheet from the trial balance. Just take the ending balances and group them as assets, liabilities, and shareholders equity in proper balance sheet format. If you do this, you should end up with a balance sheet that looks like the one we presented back in Exhibit 2.1. We realize that the odds of your flipping all the way back to page 43 right now are slim, so we ll take this opportunity to show you a slightly different balance sheet format used by some companies. Exhibit 2.10 shows an alternative balance sheet layout called the account (side-by-side) format. Accountants can use either this format or the one shown in Exhibit 2.1, just as long as it balances (that is, total assets must equal the total of liabilities and shareholders equity). Now that you ve seen how a balance sheet is created from the ending balances in ledger/t-accounts, which summarize journal entries that record each day s transactions, it s time to take a step back and think about what the balance sheet means for financial statement users.