Chapter 2. Analyzing transactions

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2 Chapter 2 Analyzing transactions 2

3 Learning objectives 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 doubleentry accounting and the normal balance of an account 3

4 Learning objectives 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 4

5 Learning objective 1 Explain the steps in the accounting cycle and each step s supporting documentation 5

6 The accounting cycle Steps and procedures that accountants follow when recording accounting information Performing the same steps each cycle helps minimize errors when recording transactions 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 6

7 Learning objective 2 Explain the purpose of source documents 7

8 Source documents 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: Invoice Purchase order Checks Bank statement Cash register tape Employee records 8

9 Learning objective 3 Describe an account and its purpose 9

10 The account After analyzing the transaction from the source document we record it in the accounting records But what are these accounting records? Accounts! 10

11 The account 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 way to record information 11

12 The account Chapter 1 introduced us to some specific accounts: Cash Accounts Payable Accounts Receivable Capital New accounts introduced in this chapter: Prepaid Expenses Unearned Revenue (Asset account) (Liability account) 12

13 Learning objective 4 Describe a chart of accounts 13

14 Chart of accounts 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? 14

15 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 15

16 Learning objective 5 Define debits, credits and account balance 16

17 Debits and credits 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? 17

18 Debits and credits 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 18

19 T-account We can see debits and credits using the T-account: Account Title Debit Dr Left side Credit Cr Right side To debit an account is to record an entry on the left To credit an account is to record an entry on the right 19

20 Account balance 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? 20

21 Calculating an account balance Example using a simple T-account: Cash No. 100 (debits) 3,000 (credits) 1,000 5,000 Balance 7,000 The Cash account has a debit balance of $7,000 There are other formats an account may take 21

22 Account formats: T-account An example of a more detailed T-account: Cash No.100 Dec. 1 Capital 2,000 Dec. 2 Supplies Loan Payable 5,000 4 Accounts Payable Revenues 3,300 9 Expenses Accounts Receivable Withdrawals 250 Balance 9,400 22

23 Account formats: Running balance format The same account - 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 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 10 Owner withdrawal of cash 250 9,400 Dr 23

24 Learning objective 6 Explain the rules of debits and credits in double-entry accounting and the normal balance of an account 24

25 Double-entry accounting 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 25

26 Rules of debits and credits 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) 26

27 Rules of debits and credits 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) 27

28 Normal balance of an account 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 Account classification: Asset Liabilities Capital Withdrawals Revenues Expenses Normal balance: Debit Credit Credit Debit Credit Debit 28

29 Learning objective 7 Transaction analysis debits and credits 29

30 Transaction analysis - debits and credits 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 Step in the accounting cycle Documentation 1. Analyze transactions Source documents 2. Journalize transactions General journal But what does journalize transactions mean? 30

31 Journalizing transactions 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 31

32 General journal Transactions are recorded in the general journal: General journal Date 2011 For each transaction, we record the: Date Account and explanation Accounts debited and credited Value of the transaction Short explanation of the transaction Post Ref. Debit Dec. 1 Cash 2,000 GJ-1 Credit Capital 2,000 (Cash investment by owner.)

33 Posting to the ledger Once transactions have been journalized, the next step in the accounting cycle is to post them to the general ledger 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 33

34 Posting to the ledger 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 34

35 Posting from the journal to the ledger 35

36 Illustration of transaction analysis 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

37 A. Cash investment by owner A. Owner invests $2,000 cash into the business Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 1 Cash 100 2,000 Capital 300 2,000 (Cash investment by owner.) Ledger posting (T-accounts): (A) 2,000 Cash No. 100 Capital No. 300 (A) 2,000

38 B. Purchased an asset with cash B. Purchased supplies for $700 cash Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 2 Supplies Cash (Purchased supplies with cash.) Ledger posting (T-accounts): Cash No. 100 (B) 700 Supplies No. 130 (B) 700

39 C. Purchased an asset on credit C. Purchased a laptop computer on credit for $2,400 Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 3 Equipment 160 2,400 Accounts Payable 210 2,400 (Purchased computer on credit.) Ledger posting (T-accounts): Equipment No. 160 (C) 2,400 Accounts Payable No. 210 (C) 2,400

40 D. Paid for an asset purchased on credit D. Paid $600 cash toward previous credit purchase Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 4 Accounts Payable Cash (Partial payment for asset purchased on credit.) Ledger posting (T-accounts): Cash No. 100 (D) 600 Accounts Payable No. 210 (D) 600

41 E. Received loan E. Received a loan of $5,000 from the bank Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 5 Cash 100 5,000 Loan Payable 250 5,000 (Received cash loan from bank.) Ledger posting (T-accounts): (E) 5,000 Cash No. 100 Loan Payable No. 250 (E) 5,000

42 F. Performed services for cash F. Performed tutoring services for $3,300 cash Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 6 Cash 100 3,300 Revenues 400 3,300 (Received cash for services performed.) Ledger posting (T-accounts): (F) 3,300 Cash No. 100 Revenues No. 400 (F) 3,300

43 G. Performed services on credit G. Performed $4,400 worth of services on credit Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 7 Accounts Receivable 110 4,400 Revenues 400 4,400 (Performed services on credit.) Ledger posting (T-accounts): Accounts Receivable No. 110 (G) 4,400 Revenues No. 400 (G) 4,400

44 H. Received cash from Accounts Receivable H. Received $800 cash from credit customers Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 8 Cash Accounts Receivable (Received cash from credit customers.) Ledger posting (T-accounts): (H) 800 Cash No. 100 Accounts Receivable No. 110 (H) 800

45 I. Paid expense with cash I. Paid $150 cash for advertising campaign Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 9 Advertising Expense Cash (Paid cash for advertising expense.) Ledger posting (T-accounts): Cash No. 100 (I) 150 Advertising Expense No. 541 (I) 150

46 J. Owner withdraws cash from business J. Owner withdraws $250 cash from the business Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 10 Withdrawals Cash (Cash withdrawal by owner.) Ledger posting (T-accounts): Cash No. 100 (J) 250 Withdrawals No. 350 (J) 250

47 K. Non business transaction 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

48 L. Prepaid expense L. Paid $360 for a 3 year insurance premium Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 12 Prepaid Insurance Cash (Paid for 36 month insurance policy for the computer.) Ledger posting (T-accounts): Cash No. 100 (L) 360 Prepaid Insurance No. 142 (L) 360

49 M. Repayment of loan M. Made a loan repayment of $500 Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 13 Loan Payable Cash (Repaid part of the principal of the bank loan.) Ledger posting (T-accounts): Cash No. 100 (M) 500 Loan Payable No. 250 (M) 500

50 N. Unearned revenue N. Received $900 cash in advance for tutoring Journal entry: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 14 Cash Unearned Revenue (Received revenue in advance.) Ledger posting (T-accounts): (N) 900 Cash No. 100 Unearned Revenue No. 230 (N) 900

51 O. Compound journal entry 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: Date Account and explanation Post Ref. Debit Credit 2011 Dec. 15 Cash Accounts Receivable 110 1,550 Revenues 400 2,000 (Performed services for cash and credit.) Post to each of the 3 accounts in this journal entry

52 Learning objective 8 Prepare a trial balance and explain its purpose in the accounting cycle 52

53 Trial balance After journalizing transactions and posting them to the ledger, the next stage in the accounting cycle is to prepare a trial balance 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 53

54 Trial balance 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 54

55 Trial balance - example No. Account Running Latte Trial Balance December 31, 2011 Debit $ 100 Cash 9, Accounts Receivable 5, Supplies Prepaid Insurance Equipment 2,400 Credit $ 210 Accounts Payable 1, Unearned Revenue Loan Payable 4, Capital 2, Withdrawals Revenues 9, Advertising Expense 150 Totals 18,900 18,900 55

56 Preparing a trial balance 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? 56

57 Trial balance errors 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 57

58 Correcting errors in the accounts 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 58

59 Limitations of the trial balance 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 59

60 Learning objective 9 Prepare financial statements from the trial balance 60

61 Financial statements Once the trial balance is balanced, we can use it to help prepare the financial statements 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 61

62 Financial statements 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 62